The Many Responsibilities of Inheriting a Home

When you inherit a home, there are three key factors to consider: the financial and legal responsibilities of the home, the tax liabilities of the home and what you’ll eventually do with the home. All of these different things relate to each other, explains Million Acres in “A Guide to What Happens When You Inherit a House.”

Let’s look at taxes first. There’s no federal tax associated with inheriting a house, but some states have inheritance taxes. For most situations, this inheritance does not lead to an immediate tax liability. When a property is inherited, the IRS establishes a fair market value for the property, which is the new basis for the property. This is a step-up basis. It is the valuation that is used to set future taxes, when the property is sold.

Capital gains are a tax relating to the profits generated from selling an asset, in this case, a house. The step up in basis means the heir only has to pay capital gains taxes, if the home is sold. The taxes will be the difference between the fair market value set at the time of the inheritance and the selling price.

If the property has a mortgage, heirs will need to know what type of mortgage it is and if it is assumable or due on sale. Most mortgage companies allow heirs to take over the payments, according to the original loan terms. However, if there is a reverse mortgage on the home, the unpaid balance is due when the person who took out the reverse mortgage dies. This usually requires the heirs to sell the home to settle the debt.

The condition of the inherited home often determines what heirs decide to do with the house. If it hasn’t been maintained and needs major work, it may be easier to sell it as-is, rather than undertake renovations. Heirs are responsible for taxes, insurance and maintenance. However, if the house is in good shape, it may make sense to keep it.

What happens when siblings inherit a house together? That can get complicated, if each person has a different idea about what to do with the house. One may want to sell now for cash, while another may want to rent it out for income. What ultimately happens to the property, may depend on how well the siblings communicate and make decisions together.

Often the best option is to simply sell the home, especially if multiple heirs are involved. Note that there are costs associated with the sale of the house. This includes any outstanding debts, like a mortgage, the cost of fixing up the home to prepare it for sale, closing costs and fees and real estate agent commissions. If there is a profit on the sale of the home from the tax basis at the time of inheritance, the heirs may need to pay short-term or long-term capital gains tax, depending on how long they held the property.

Talk with an estate planning attorney about managing the sale of the family home. They will be able to guide you, advise you about taxes and keep the family moving through the process of settling the estate.

Reference: Million Acres (December 4, 2019) “A Guide to What Happens When You Inherit a House”

Can You Explain the Concept of Step-Up Basis?

If you inherit assets—especially real property—you need to understand the step-up in basis rules. These rules can save you a lot of amount of money on capital gains and depreciation recapture taxes.

Motley Fool’s recent article on this subject asks “What is a Step-Up in Basis?” The article explains that step-up in basis has significant implications for inherited property. When an asset is inherited because the original owner has passed away, in many cases, it’s worth more than when it was first purchased. To avoid a huge capital gains tax bill when the inherited property is sold, the cost basis of the asset is modified to its value at the time of its owner’s death. This is called a step-up in basis. Note that this only applies to property transferred after death. If a property was gifted or transferred before the original owner dies, the original cost basis would transfer to the recipient.

This is a gigantic tax benefit for estate planning, regardless of whether you go ahead and sell the inherited asset immediately or hold on to it for a time. While a step-up in basis can let heirs avoid capital gains taxes, it doesn’t allow heirs to avoid estate taxes that apply to big inheritances.

The estate tax this year is imposed on property in excess of $11.4 million per individual and $22.8 million per married couple. Therefore, if you and your spouse leave a $25 million estate to your heirs, $2.2 million of this will still be taxable, even though your heirs’ cost basis in assets they inherited will be stepped up for capital gains tax purposes.

There are many strategies that a qualified estate planning attorney can advise you on to avoid estate taxes, but step-up in basis doesn’t exclude the value of inherited property from a taxable estate all by itself.

There are two significant ramifications of stepped-up cost basis regarding inherited real estate assets. First, like with other assets, you don’t have to pay capital gains on any appreciation that occurred before you inherited the property. Selling an investment property after years of holding it, can mean a massive capital gains tax bill. Therefore, a stepped-up cost basis can be a very valuable benefit. A step-up in basis can also give you a larger depreciation tax benefit. The cost basis of residential real estate can be depreciated (deducted) over 27½ years: a higher number divided by 27½ years is a greater annual depreciation deduction than a smaller number would produce.

Estate transfers are pretty complicated, so work with a qualified estate planning attorney.

Reference: Motley Fool (November 21, 2019) “What is a Step-Up in Basis?”

If My Mom Wants to Give Me Her House, Is It Better to Inherit or Buy It?

Say that your mom owns a house without a mortgage, and she’d like to transfer the house to her adult son and daughter. The issue is whether it’s a better strategy to make the transfer via gift or a sale. Let’s throw in the fact that the son is a U.S. citizen, but the mom and sister are citizens of France.

Some major tax consequences need to be considered, advises nj.com in its recent post, “What happens when a non-citizen wants to transfer a home to an heir?”

First, understand that if the son, a U.S. citizen, receives a gift of money or other property from a foreign person, he may need to report these gifts on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.

Note the difference: this an information return—not a tax return. However, there are significant penalties for not filing it. The IRS says that U.S. persons (and executors of estates of U.S. decedents) must file Form 3520 to report:

  • Certain transactions with foreign trusts;
  • Ownership of foreign trusts under the rules of Internal Revenue Code §§ 671 through 679; or
  • Receipt of certain large gifts or bequests from certain foreign persons.

As to whether a gift or a sale is better off for the adult child and his mother, consider that the children keep the parent’s cost basis on lifetime transfers of property made by the parents.

That means that if the mom’s home was purchased for $100,000 and it now has a current market value of $250,000, the cost basis of $100,000 becomes the child’s cost basis. When you sell the property, the capital gains tax on the difference between the sale price and the cost basis—$150,000—would have to be paid.

However, if the sister and brother inherit the property, they will receive a “step up” in the cost basis. Thus, if at the Mom’s death, the property is worth $250,000 and it is sold by the child for that amount, there’s no gain on which to pay a capital gains tax.

If you’re in this situation, it’s wise is to talk with an estate planning attorney to help your family with sound planning strategies. They will be able to help work out the best possible solution.

Reference: nj.com (September 24, 2019) “What happens when a non-citizen wants to transfer a home to an heir?”

Do It Yourself Wills Go Wrong–Fast

What happens when a well-meaning person decides to create a will, after reading information from various sources on the internet? There’s no end of problems, as described in the Glen Rose Reporter’s article “Do-it-yourself estate plan goes awry.”

The woman started her plan by deeding her home to her three children, retaining a life estate for herself.

By doing so, she has eliminated the possibility of either selling the house or taking out a reverse mortgage on the home, if she ever needs to tap its equity.

Since she is neither an estate planning attorney nor an accountant, she missed the tax issue completely.

By deeding the house, the transfer has caused a taxable transaction. Therefore, she needs to file a gift tax return because of it. At the same time, her life estate diminishes the value of the gift, and her estate is not large enough to require her to actually pay any tax.

She was puzzled to learn this, since there wasn’t any tax when her husband died and left his share of the house to her. That’s because the transfer of community property between spouses is not a taxable event.

However, that wasn’t the only tax issue to consider. When the house passed to her from her husband, she got a stepped-up basis, meaning that since the house had appreciated in value since she bought it, she only had to pay taxes on the difference in the increased value at the time of her husband’s death and what she sold the property for.

By transferring the house to the children, they don’t get a stepped-up basis. This doesn’t apply to a gift made during one’s lifetime. When the children get ready to sell the home, the basis will be the value that was established at the time of her husband’s death, even if the property increased in value by the time of the mother’s death. The children will have to pay tax on the difference between that value, which is likely to be quite lower, and the sale price of the house.

There are many overlapping issues that go into creating an estate plan. The average person who doesn’t handle estate planning on a regular basis (and even an attorney who does not handle estate planning on a regular basis), doesn’t know how one fact can impact another.

Sitting down with an estate planning attorney, who understands the tax issues surrounding estate planning, gifting, real estate, and inheritances, will protect the value of the assets being passed to the next generation and protect the family. It’s money well spent.

Reference: Glen Rose Reporter (September 17, 2019) “Do-it-yourself estate plan goes awry”

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