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As a Certified Financial Planner, I'm often asked about issues
regarding inheritance, gifting and the resulting taxes. Here's a
classic example of just how complicated these situations can be,
using a question from a reader in Michigan we'll call Bob.
Bob writes, "I have a question about my mom's home that I inherited.
Before my mom died she put her real estate into joint ownership
between her and my sister. It was supposed to help make settling her
estate easier. Before mom passed away, my sister died. After my
sister died, mom placed the real estate jointly between herself and
me. Mom passed away over a year ago and I am now contemplating the
sale of her house. After mom's death I had the home transferred to
my and my wife's names.
What are my capital gains liabilities on the sale of the house? Do I
pay capital gains on the whole sale, half the sale, or none of the
sale?"
Bob's lack of knowledge is nothing out of the ordinary. Few people
are aware of the tax implications and needlessly end up creating a
tax headache for themselves and their loved ones.
Let's explain what an inheritance is and how it differs from a gift.
An inheritance is money, property, or another asset of value that is
transferred after death. A gift occurs when money, property or other
assets are transferred before death. An inheritance and a gift are
handled very differently from a tax standpoint.
Each of us can give gifts up to $12,000 per year to any person we
want without any Federal tax implications. (There may be some state
gift tax implications so check with an accountant.)
Inheritances aren't subject to Federal Estate Tax unless the
estate's value is over a certain amount, which is currently two
million dollars. Because all assets owned by the deceased are
included in the estate's valuation (i.e. retirement accounts,
annuities, life insurance, etc.), reaching that two million dollar
limit is easier than you think.
Even if there is no gift or estate tax when the assets are
transferred, there can be capital gain taxes when the assets are
sold. The trick is determining the asset's original value, or cost
basis, and that depends on whether the asset was a gift or an
inheritance.
When you receive a gift, you also receive the cost basis the person
giving the gift had. So, if a parent paid $10,000 for a home and it
was worth $100,000 when it was gifted to the child, the child now
has a cost basis of $10,000. If the house is sold 5 years later for
$125,000, the child will owe taxes on a gain of $115,000.
If the house was instead inherited by the child, the cost basis is
the value of the house at the time of inheritance, which in our
example would be $100,000. So when the house is sold 5 years later
for $125,000, the child only owes taxes on the gain of $25,000. In
tax parlance, the house received a step-up in basis when transferred
after death. It doesn't receive a step-up if transferred prior to
death.
Let's apply this to Bob's situation. When Mom added Sister's name to
the deed, it was a gift to the sister of 50% of the value of the
home and Sister's cost basis was 50% of Mom's cost basis.
When Sister died and the house transferred back to Mom, it was
considered an inheritance. So Mom's cost basis on the 50% she
inherited was the market value at the time she inherited it back. So
50% of Mom's ownership is based on her original cost basis and the
cost basis of the other 50% is the value at Sister's death.
When Mom then adds Bob's name to the property, it's another gift. So
Bob will inherit 50% of Mom's new, adjusted cost basis. When Mom
dies and the other 50% is transferred to Mr. K, his cost basis in
that 50% is the value at the time of Mom's death. Now you know why
accountants make all that money!
If Mom had used a Living Trust instead, there would have been no
need to add names to her house and her heirs would have 100% of
stepped up cost basis, saving thousands of dollars in taxes.
In addition to being a nationally syndicated columnist and Certified
Financial Planning Practitioner, Mr. Voudrie provides personal,
private money management services to clients nationwide. |
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