My wife will be inheriting her father's home when he passes. We intend to sell our home and invest the proceeds to remodel this inherited property. What is the tax process since we would not be using our sale proceeds towards the purchase of this new home? This would be our principal residence.
-Joe, South Dakota
Dear Joe,
You are very wise indeed! Taking the proper steps beforehand to understand the tax implications of using the proceeds from selling your current residence to make improvements on the home your wife will inherit will help you and your wife build a strong and confident financial foundation. Although the deferral on the gain from the sale of a principal residence is no longer applicable, the home sale gain exclusion is available and allows an individual to omit some of the gain from the sale of their home. Nothing puts a damper on a great plan like an unexpected bill from the IRS or state tax agency. As Thomas Edison said, “Good fortune is what happens when opportunity meets with planning.”
Let’s look at the tax implications of selling your current personal residence. If you and your wife file a joint return and otherwise qualify, you may be able to shelter as much as $500,000 ($250,000 each) of potential gain from tax when you finally sell the home, if both the following are true:
- Ownership Test: If filing jointly, you or your wife owned the home for at least two out of the last five years ending on the date the house is sold. If both of you owned the home together or your home is in the name of your revocable grantor trust, that is fine too! (A revocable grantor trust is a document where the grantor (the person(s) that create and fund the trust) can still make changes to the trust, including reverting the assets that were placed in the trust back into the name of the grantor.) If you choose to file as married filing separately, then each of you will need to have met the ownership test to be eligible to claim any of the exclusion on your individual returns.
- Use Test: Both you and your spouse (if you file a joint return) lived in the home for at least two out of the last five years ending on the date the house is sold.
If you claimed the principal residence exclusion on another residence within two years of selling your current home, then it is possible you may qualify to claim a partial exclusion, depending on your facts and circumstances.
Before you can calculate the gain or loss on the sale of your home, you need to figure out the home’s adjusted basis. In broad terms, the home’s basis is the total that was paid to build or purchase the home, including any allowable settlement costs paid minus any points that were paid by the seller. The adjusted basis takes the original basis of the home and adjusts it by certain costs that occurred during home ownership. Expenses that add to the basis of the home include:
- The cost of any substantial improvements made to the home (this does not include repairs).
- Any amounts paid to restore the home after a casualty, such as a natural disaster.
- Assessments on the property for local improvements, such as sidewalks, water connections, roads, etc.
- Certain costs you paid on behalf of the seller when you originally purchased the home. This may include any real estate taxes you paid that were due before the day you purchased the home. Generally, real estate taxes owed up to the date of sale are the seller’s responsibility.
Just as certain costs increase the basis of the home, there are items that decrease its basis and include:
- Payments received for granting an easement or right-of-way on the property.
- Any depreciation allowed or that was allowable for the business use of the home. This includes depreciation from a home office or during the time the home or even part of the home was used as a rental.
- Any qualified principal residence mortgage that was forgiven and excluded from income.
- Deductible casualty losses and any insurance payments received or that you expect to receive for a casualty loss.
Once upon a time, taxpayers were able to defer (postpone) the tax on the realized gain from the sale of their home if another principal residence was purchased of greater value. However, this provision has not been available since May 1997. Although this gain deferral election is no longer available, taxpayers who took advantage of the gain deferral when they purchased their current residence will need to reduce the basis of their home by that gain amount.
Unless a lien has been placed on your home because there is an outstanding debt you or your wife owe, you should be able to take the proceeds from the sale of your home and use it to make improvements on the home your wife will inherit.
Generally, when a person dies, the assets they owned at the time of their death get a new basis or valuation. This new basis is either the fair market value of the property as of the date of person passed or the fair market value six months from the date of passing, which is known as the
alternate valuation date. If the asset is sold, exchanged, or distributed to the person who is inheriting it within the first six months of the person’s passing, then the asset’s basis is its fair market value as of the date the owner died. Whether the date of death or alternate valuation date is used is a decision that is made by the person appointed to administer the deceased person’s estate. As with most tax rules, there are exceptions to the basis rules when a person dies, so your wife will want to discuss the basis of the home with the administrator of her father’s estate. Additionally, your wife should receive documentation explaining her portion of the inheritance, including the fair market value of the assets she receives. The cost of any improvements you make on the home your wife inherits will be added to the basis of the home.
Feeling a little overwhelmed by the information above? Here’s an example that hopefully ties the above key points together.
Example: Percy and Peggy love the home they bought close to twenty years ago. When they bought their home, they got a sweet deal and only paid $200,000. Throughout the years, they added a master bedroom with an ensuite, a pool, and remodeled the kitchen and guest bathroom. In total, they paid an extra $150,000 for these improvements. Although they have enjoyed their home, their once quiet neighborhood has become overcrowded and loud.
In early 2020, Peggy’s father passed away and she inherited her father’s home, which is in a quiet hamlet twenty miles away. The home is well over ninety years old and in need of many upgrades. Wanting to get away from the hustle and bustle of the city, Peggy and Percy decide to sell their home and move to Peggy’s father’s house. They plan to use the proceeds from the sale of their home to remodel Peggy’s childhood home and bring it into the twenty-first century.
Although Percy and Peggy are longing for a quieter life, many folks are wanting to be close to the city, so they received several offers. A bidding war ensued, and they were able to sell their home for $925,000. Taking into consideration their adjusted basis in the home selling expenses, their gain on the sale of the home was $555,000 and calculated as follows.
Selling Price: $925,000 minus
Selling expenses: $20,000 minus
Adjusted basis in the home: $350,000 equals
Purchase Price: $200,000
Renovations: $150,000
Gain on the sale of the home: $555,000
Since both Percy and Peggy owned and lived their home for more than two out of the last five years, they were each able to exclude $250,000 of gain. They filed a joint return and excluded $500,000 of the gain on the sale of the home on their 2020 return. Although they sold their home for $925,000, they only had a reportable tax gain of $55,000.
The executor of Peggy’s dad estate transferred the home to Peggy within a few months after he died. Peggy’s dad purchased the home sixty years ago for $65,000. When her dad died, the fair market value of the home was appraised at $275,000, which becomes Peggy’s basis in the home. It will be important for Percy and Peggy to keep good records of all the major home improvements they do on the home as the costs will increase their basis in the home and help to reduce any possible gain if they decide to sell the home in the future.
You mention that you are from the Mount Rushmore State. The good news is South Dakota does not have a state income tax or an inheritance tax. So, if your father-in-law’s home is also located in South Dakota, your potential tax liability would be limited to your federal taxes.
Wishing you wisdom in your future tax endeavors and many happy returns,
Jean Lee Scherkey, EA