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What tax traps do adult children face in selling parents’ home?

by on
in Small Business Tax,Small Business Tax Deduction Strategies

M.W. from Rockville, Md. writes:


Seven years ago, my parents gave their house in upstate New York to the children and their spouses. (There are five of us; four are married.) My parents paid $150,000 for the house, and now it's worth more than $500,000. Now that both parents have passed away, we're thinking of selling the home. But we're not sure if that's a good idea from a tax perspective and whether we'd qualify for the home-sale exclusion. What do you think?


Obviously, you're facing more than just tax issues. But let's assume that none of the children currently reside in the home—it doesn't appear so from your question—and no one has an interest in living there. Barring any other extenuating circumstances, each sibling pays a portion of the capital gains tax due when selling the home. But even so, you'll come out with plenty of cash after taxes. Here's why:


Tax law allows you to exclude up to $250,000 ($500,000 if you're married and filing jointly) of the proceeds received from the sale of a principal residence. But since none of the siblings occupied the home as a principal residence, none of you is eligible for the home-sale exclusion. To qualify, someone needs to move into the home for at least two years and only that person (or couple) becomes eligible for the exclusion.


If you sold the home today, you'd use your parents' $150,000 tax basis in the home. So each sibling's basis becomes $30,000 (based on 20 percent ownership and a $150,000 basis).


But the news isn't all bad. The 2003 tax law lowered the maximum capital gains tax rate to 15 percent (down from 20 percent). Assuming you sell the home for $550,000—a total gain of $400,000—the tax for each sibling amounts to $12,000 (15 percent of $80,000, which is one-fifth of the total $400,000 gain). So you'd each pocket $98,000 from the sale ($110,000 sale proceeds minus $12,000 tax).


Final thought: You can also increase the basis for the home by adding improvement costs.


For instance, say your parents added a pool, deck and finished basement over the years, for a total of $100,000 in improvements. That reduces the overall taxable gain to $300,000 and your share of the tax bill to $9,000 (15 percent of $60,000, which is one-fifth of the total $300,000 gain). Collect documentation for any home improvements to prove that point.

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