Qualifying for home-sale tax break after spouse dies

5 requirements must be met

DEAR BENNY: I have a question about the tax exclusion for married couples when you sell your house. Is there a time frame from when a spouse dies that you would be able to receive the $500,000 tax exclusion when you sell your house? –Christine

DEAR CHRISTINE: Good question. And it’s a bit confusing. Current law allows homeowners who sell their principal home the right to exclude up to $500,000 of their profit if they file a joint tax return (or up to $250,000 if single). There are two important tests: (1) use — you must have used, i.e., lived in, the house for two out of the five years before it is sold. That does not mean that you lose that exclusion if you take a vacation, but you do have to maintain the house as your principal residence, aka your "main home," in the words of the Internal Revenue Service; (2) ownership — you also must have owned the property for two out of the five years before it is sold.

In Publication 523, Selling Your Home, the IRS answers your question as follows: "If your spouse died and you did not remarry before the date of sale, you are considered to have owned and lived in the property as your main home during any period of time when your spouse owned and lived in it as a main home."

Accordingly, if you meet all of the following requirements, you may exclude up to $500,000 of any gain from the sale of your home: (1) the sale took place after 2008; (2) the sale or exchange took place no more than two years after the date of death of your spouse; (3) you and your spouse met the use test at the time of your spouse’s death; (4) you or your spouse met the ownership test at the time of your spouse’s death, and (5) neither you nor your spouse excluded gain from the sale of another home during the last two years before the date of death.

I suggest that if you have any questions about these requirements, talk with a lawyer. If your husband recently died, you probably have been in contact with legal counsel in any event.

DEAR BENNY: I live with my 87-year-old, widowed mother. Five years ago, she had the house title changed to add my sister and me to it (no other heirs) because she wanted us to be able to sell if she needed to go into a nursing home and also to avoid probate. She has no will and no other significant assets. Our names are also on her bank accounts.

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Since then, I have acquired her durable power of attorney since she cannot sign her name anymore.

We have no plans to sell the house before her death, but am wondering now about inheritance taxes and/or other taxes with the house after her death. (She still lives in the house and we expect her to stay until her death, which is not imminent.)

Is it better to leave the title as is or revert the house title back to her name? (She would not be able to sign it, but, as power of attorney, I guess I could.)

If the title remains in our names, would we have to pay any inheritance taxes on the house (1) upon her death, and (2) if I continue to live here after her death? (The original purchase cost was $125,000, but is probably worth about $200,000 now.) –Anne

DEAR ANNE: Let me answer each question separately.

The only benefit to redeed the property back into your mother’s name would be that on her death, you and your sister would get what is known as the stepped-up basis for tax purposes. When your mother added you and your sister to the title, since you did not pay her anything, it is considered to be a gift. And thus her basis for tax purposes becomes yours.

What does this mean? Ignoring for this example any improvements that have been made to the house (which will increase the tax basis), your mother’s basis is $125,000. When she added your names, that means that the basis remains at $125,000. If you both were not on title, and the value of the house on the date of her death is $200,000, you and your sister’s basis would be that higher number. So if you were to sell it for that price, you would have made no gain and thus no capital gains tax to pay.

However, since your basis is now the lower one, on your mother’s death, her one-third interest would be stepped up to market, but you and your sister’s basis would still be the lower one. And if you were to sell, you probably would have to pay some capital gains tax.

As for inheritance tax, that depends on your state law, which you should discuss with a financial adviser. The house would be an asset for state and federal estate tax purposes, but from what you have told me, I doubt that it is big enough to have any estate taxes to pay.

You should know, however, that if you redeed the property back to your mother, you may have to pay a recordation/transfer tax to your state. However, many states actually exempt transfers from child to parent (or parent to child) from such taxes.

There should be no inheritance tax upon mom’s death if title stays with children no matter when it is sold; if you live in the property and have been a partial owner for two out of the five years before sale, you should be able to exclude up to $250,000 of gain. But your sister, unless she also owned and lived in the property, would have to pay some capital gains tax.

DEAR BENNY: When we sold our home in Wisconsin the septic system inspector noted the "septic drain field mottling" was too close to the top of the ground. In his report, he noted the septic system was operating properly but probably would not pass inspection. The buyer wanted us to replace the field with an engineered system.

We finally agreed to pay the buyer $4,000 to replace the septic field. This $4,000 is a line item "Rebate to buyer for septic system repair" on our closing statement and on the title company’s statement. Now, two years later, the buyer is selling the property and the septic system has not been replaced. Can I ask for my $4,000 back if he sells the house without replacing the septic system? –Dave

DEAR DAVE: Nice try, but I am afraid the answer is no. You made a deal with your buyer that was for your benefit; presumably he would not have bought the house without your $4,000.

In hindsight, you could have initially agreed with your buyer that you would pay for the installation of the system after it was installed, but I doubt any of us would have thought of this at the time the sales contract was being negotiated.

Bottom line: Your buyer has a windfall and there is really nothing you can do about it. Sorry.

DEAR BENNY: I am looking for a modification on my existing mortgage. My current lender is unwilling to modify my loan. It’s not a Fannie Mae or Freddie Mac loan.

Here is my situation: My home is upside down by $100,000, and I am stuck with a 6 percent interest rate. My credit is excellent at 851, and I have not missed a payment. Is there any hope to modify my loan or do I just walk away? –Vince

DEAR VINCE: This is an area that is confusing both within the government as well as with lenders. There is a program called HAMP (Home Affordable Modification Program), and there is a lot of helpful information on the Internet. I suggest that you go to your favorite search engine and type in "loan modification." There you will find a large number of sites to review.

You should also contact your local U.S. congressman or senator; their offices should be able to provide you information specific to your state.

Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

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