A mother who just turned 75 wants to downsize from her four-bedroom house. Her husband passed away six years ago, and she owns her home outright. At the time of her husband’s death the value of the house was estimated at $1.2 million. Right now she has enough income from retirement accounts and investments to live comfortably. She could even buy another smaller property if need be. The executor of her estate is trying to help her decide what to do with the house. She could let another family member live in it who couldn’t pay rent but could help with upkeep; she could rent it out for market value; or she could sell.

What should she do?

If she hasn’t already, an article in The LA Times titled “Consider tax implications when downsizing,” recommends that she needs to hire an experienced estate planning attorney who can help her evaluate her options.

If she sells, she could possibly be in for a shock because there might be a considerable capital gains tax on the sale. Federal law permits a set amount of capital gains on the sale of a primary residence ($250,000 per person) to be excluded from income. However, anything above that amount would be taxed heavily as a capital gain.

The capital gain is determined by the difference between the home’s sale proceeds and the seller’s tax basis in the home. In this scenario, at least half of the home receives a “step up” in basis to the then-current market value when the husband passed away. If the mom lives in a community property state, e.g., California, the entire property would have received this step up at his death. As a result, any increase in value since the husband’s death would be subject to capital gains tax (minus the $250,000 federal exclusion).

Keep in mind, that if the mom dies while still owning this house, her heirs would get a tax basis equal to the property’s value at her death. So no matter what state she lived in, none of the house’s appreciation during her lifetime would be subject to tax.

Tax issues alone shouldn’t dictate what your parents decide, however you all should consult with an experienced estate planning attorney to learn about these and other issues in order to make an informed decision about their next steps.

For more information about estate planning, please visit my estate planning website.

Reference: LA Times (December 28, 2014) “Consider tax implications when downsizing”