Estate planning and capital gains taxes: What you need to know before selling high value property that could be inherited.

Q: My parents are elderly and live in Virginia. They own a rental house in California. Since they bought it, the home has increased greatly in value to about $1 million. They are trying to decide if they need to live in the home for two years before selling it, in order to avoid capital gains taxes.

My father is very ill, so a major change like that would be difficult. Likely, he will predecease my mother. According to his will, she will inherit everything. Would the house then be assessed (for purposes of determining the capital gains tax) according to its current value? Is it possible that she won’t need to move to California for two years in order to avoid the tax penalty?

A: With home values this large, your parents might benefit from the advice of an estate planner to go over not only this property, but other real estate and assets they own. You should know that even if your parents lived in the home for two out of the last five years, they would only be entitled to exclude from federal income taxes $500,000 as a married couple. (Individuals get to exclude $250,000.)

If your parents purchased the home for $250,000 and now it’s worth $1,000,000, they have a profit of $750,000. (We’re making this simple and not including costs of buying or selling the home.) That results in a profit of $750,000. The IRS would permit them to avoid any taxes on $500,000 but they still would have to pay capital gains taxes on $250,000. Since you indicated that it was a rental property, they would pay capital gains taxes on $750,000. But it gets complicated.

We don’t think it’s realistic for your parents at their age and with their health issues to try to move to California at this time. Even if they started using the home as their primary residence and lived there for two years so that the IRS would consider the home their primary residence, the fact that the home was an investment property would require your parents to pay capital gains taxes on the profit anyway. They probably would not be entitled to take the full advantage of the $500,000 primary home exclusion as the IRS would require them to consider the time the home was an investment property and the time the home was a primary residence.

So, now that the home will stay as an investment property, your mother can continue to rent the property and reap the benefits of the home as an investment property. If she decides to sell the home and your dad is no longer around, what she would pay in taxes may depend on how they owned the investment home. If they owned it jointly, your mom may have her own basis (or what it cost her) and your dad would have his own basis for IRS tax purposes. At the time of your dad’s death, your mom might inherit your dad’s share at the home’s value at or around the time of his death.

Going back to our example, if your father dies and the property is valued at $1 million, your mom would inherit his half at $500,000. If your mother sells the property at that point, she would have a split basis, but would pay substantially less in capital gains tax. If she keeps the property, when she dies, you would inherit the property at its then current value. Unless your parents have an extraordinary amount of assets, the property would pass to you tax free.

As you can see there are quite a number of moving parts. We encourage you to talk to a tax professional or an enrolled agent to help you understand the tax consequences of owning the home in California. That tax professional (and even an estate planner) might have some solutions for you to assist your parents in these difficult times. The estate planner may have ideas on how they should own the property to minimize the paperwork when your parents die and to also minimize the impact of both federal income taxes and state income taxes for California and in Virginia.

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