How to avoid paying capital gains tax on inherited property. Minimize the potential tax consequences of transferring property from parent to child.
Q: I have a question about a recent answer you gave to a reader. The question relates to a daughter that acquired her share of the home from her mom while her mom was alive. In your answer you mentioned that the home was purchased originally for $50,000 and later sold for $250,000.
You stated that the daughter would pay federal income taxes on one-half of the increased value of home or $100,000. My question has to do with the daughter buying her interest and then living in that home for two out of the last two years with her mother as a primary residence. Would the daughter pay any taxes when she or they sold the home?
Paying Capital Gains Tax on Sale of Primary Residence
A: When a person buys a home, and lives in that home as their primary residence for 2 out of the last 5 years, that homeowner is entitled to exempt up to $250,000 of profit (gain) from any federal income taxes. If the homeowner is married, the married couple can exclude from tax up to $500,000 in profits.
So, the short answer to your question is if the daughter purchased her interest in the home from the parent and qualifies for the exclusion, the daughter wouldn’t have to pay any federal income taxes on the sale of the home.
Additionally, there are additional rules that allow service members to still get some of the benefit from the exclusion due to deployment or relocation due to military requirements. Other homeowners may have a reduced benefit depending on their circumstances. For more information on these rules, you can review Publication 523 on the Internal Revenue Service website at www.IRS.gov.
Transferring Ownership of the Home from Parent to Child
Remember, in the question you were referring to, the mother gave her half interest in her home to her daughter. In that situation, the daughter did not live with her mother so when they sold the home, her mother could benefit from the $250,000 exclusion but not the daughter. Furthermore, the daughter did not inherit the home from the mother, the daughter received her half interest from the mother so the daughter’s “cost” was what the mother paid for the home.
As we enter this new year, many older homeowners start to think about their assets and believe that adding their children’s name to the title to their home will help their kids out after they pass. The goal for the parent is to have an easy method of transferring the ownership of the home from the parent to the child. If the home’s value has not increased much and the child won’t incur federal income taxes on the sale of the home, this process could work. But if the child will incur steep income taxes on the sale after the parent has died, transferring ownership to the child this way would be the wrong thing to do.
How to Avoid Paying Capital Gains Tax on Inherited Property
Let’s say the child (in the example you cite) ends up having to pay $20,000 in federal income taxes on the $100,000 in profits on the sale of the home. The child could have avoided paying those taxes entirely if the parent had simply kept ownership of the home and the child had inherited the home. Yes, the child might have to pay an attorney to probate the will and obtain title to the home, but the cost of probating the will would have been far less than the $20,000 in federal income taxes.
On the other hand, if the parent had gone to an estate planning attorney and put the home into a living trust, the daughter could have inherited the home through the trust and would not have had to pay any federal income taxes on the sale of the home. The only cost to the parent would have been the setup of the living trust and the cost of the paperwork to put the property into the trust. Again, the costs here would have been far less than the $20,000 in federal income taxes.
So, as we move into 2020, you need to put some thought into how you want your assets to go to your children or other heirs. A seemingly simple solution (a quitclaim deed) could actually be the most costly.
Timing the Sale of the Home to Avoid Paying Capital Gains Tax
One last item, to avoid paying federal income taxes on inheriting the home, the person inheriting the home will usually need to sell the home within a year after the death of the loved one. The IRS will generally give the home a value equal to what the home sells for within a year after the death of the parent. So even if the home value continues to go up after the parent dies, if the child sells the home within a year of the death, the child won’t pay any taxes on an inherited home.
There are other factors and other information to consider when thinking about an estate plan and for that information on larger estates, you should talk to an estate planner or tax attorney. Thank you for your question.