Taxes on a Primary Residence and Inherited Property

The information on this page was taken from the IRS website

Taxpayers are assessed taxes on the gain they receive from their capital assets. The gain is determined by subtracting the market value of the asset from the basis of the asset. The basis is determined by adjusting the acquisition cost for various allowable related costs or improvements to the property. Capital gains for tax purposes are considered either long term capital gains or short-term capital gains. A short-term capital gain is a result of an asset held for one year or less. Calculating short-term and long-term capital gains is somewhat complicated and we won't go into it in this discussion.

Taxpayers can also reduce their taxable income by applying losses on capital assets. The IRS recognizes two types of losses, long term capital losses and short-term capital losses. Short-term losses are on assets held for one year or less. Calculating short-term and long-term capital losses is complicated and we won't discuss it in this section.

What is important to taxpayers is to understand that short-term gains are taxed based on the marginal rate of the taxpayer. Long term capital gains are fixed at a lower tax rate than the marginal rate. For tax planning purposes, it is important maximize long term capital gains and minimize short-term capital losses while at the same time maximizing short-term capital losses and minimizing short-term capital gains.

Capital Gains on a Primary Residence

Profits on real estate that is used as your primary residence may qualify for a very special capital gains exclusion of $250,000 or $500,000. If you are selling your main home, be sure to check out Taxes on the Sale of Your Home. If the real estate is not your primary residence, such as a second home, the real estate is treated as a short-term or long-term capital gain, depending on how long you have owned the house.

Usually, the home you live in most of the time is your main home and can be a:

• House,
• Houseboat,
• Mobile home,
• Cooperative apartment, or

To exclude gain under the rules in this publication, you in most cases must have owned and lived in the property as your main home for at least 2 years during the 5-year period ending on the date of sale.

To figure the gain or loss on the sale of your main home, you must know the selling price, the amount realized, and the adjusted basis. Subtract the adjusted basis from the amount realized to get your gain or loss.

Here is the formula for determining your gain or loss:

SELLING PRICE minus SELLING EXPENSES = AMOUNT REALIZED minus ADJUSTED BASIS = GAIN OR LOSS

Capital Gains on Inherited Property or Gifted Property

As a general rule, property received as a gift retains the basis in the property from the gifting owner. What this means is that generally, after certain adjustments, the person receiving the gift must pay capital gains on the difference between the selling price of the property and the basis -- which is what the original owner typically paid for it after certain adjustments in the tax code. To determine whether it is a long-term capital gain or short-term capital gain, the person receiving the gift also receives the holding period of the person gifting. If the original owner held the property more than a year then the capital gain is a long term capital gain.

Inherited property generally has a more favorite capital gains tax treatment. Although there are several options under the code, as a general rule, inherited property steps up the basis of the property at death to what would have been the fair market value of the property at the death. In essence, the net effect is that there is little if any capital gains when the property is sold because the new basis in the property would be very close to the selling price. This is a special provision in the code that provides a special tax break to heirs of capital property.

Property Received As a Gift

To figure the basis of property you receive as a gift, you must know its adjusted basis (defined earlier) to the donor just before it was given to you, its FMV (Fair Market Value) at the time it was given to you, and any gift tax paid on it.

If the FMV of the property at the time of the gift is less than the donor's adjusted basis, your basis depends on whether you have a gain or a loss when you dispose of the property. Your basis for figuring gain is the same as the donor's adjusted basis plus or minus any required adjustment to basis while you held the property. Your basis for figuring loss is its FMV when you received the gift plus or minus any required adjustment to basis while you held the property (see Adjusted Basis, earlier).

If you use the donor's adjusted basis for figuring a gain and get a loss, and then use the FMV for figuring a loss and have a gain, you have neither gain nor loss on the sale or disposition of the property.

Example.
You received an acre of land as a gift. At the time of the gift, the land had an FMV of $8,000. The donor's adjusted basis was $10,000. After you received the land, no events occurred to increase or decrease your basis. If you sell the land for $12,000, you will have a $2,000 gain because you must use the donor's adjusted basis ($10,000) at the time of the gift as your basis to figure gain. If you sell the land for $7,000, you will have a $1,000 loss because you must use the FMV ($8,000) at the time of the gift as your basis to figure a loss.

If the sales price is between $8,000 and $10,000, you have neither gain nor loss. For instance, if the sales price was $9,000 and you tried to figure a gain using the donor's adjusted basis ($10,000), you would get a $1,000 loss. If you then tried to figure a loss using the FMV ($8,000), you would get a $1,000 gain.

Inherited Property

If you inherit property, you are considered to have held the property longer than 1 year, regardless of how long you actually held it.

Your basis in property you inherit from a decedent is generally one of the following.

1. The FMV of the property at the date of the individual's death.

2. The FMV on the alternate valuation date if the personal representative for the estate chooses to use alternate valuation. For information on the alternate valuation date, see the instructions for Form 706.

3. The value under the special-use valuation method for real property used in farming or a closely held business if chosen for estate tax purposes. This method is discussed later.

4. The decedent's adjusted basis in land to the extent of the value excluded from the decedent's taxable estate as a qualified conservation easement. For information on a qualified conservation easement, see the instructions to Form 706.

If a federal estate tax return does not have to be filed, your basis in the inherited property is its appraised value at the date of death for state inheritance or transmission taxes.

Appreciated Property

The above rule does not apply to appreciated property you receive from a decedent if you or your spouse originally gave the property to the decedent within 1 year before the decedent's death. Your basis in this property is the same as the decedent's adjusted basis in the property immediately before his or her death, rather than its FMV. Appreciated property is any property whose FMV on the day it was given to the decedent is more than its adjusted basis.

Community Property

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), husband and wife are each usually considered to own half the community property. When either spouse dies, the total value of the community property, even the part belonging to the surviving spouse, generally becomes the basis of the entire property. For this rule to apply, at least half the value of the community property interest must be includable in the decedent's gross estate, whether or not the estate must file a return.

For example, you and your spouse owned community property that had a basis of $80,000. When your spouse died, half the FMV of the community interest was includible in your spouse's estate. The FMV of the community interest was $100,000. The basis of your half of the property after the death of your spouse is $50,000 (half of the $100,000 FMV). The basis of the other half to your spouse's heirs is also $50,000.

Property Held by Surviving Tenant

The following example explains the rule for the basis of property held by a surviving tenant in joint tenancy or tenancy by the entirety.

Example.
John and Jim owned, as joint tenants with right of survivorship, business property they purchased for $30,000. John furnished two-thirds of the purchase price and Jim furnished one-third. Depreciation deductions allowed before John's death were $12,000. Under local law, each had a half interest in the income from the property. At the date of John's death, the property had an FMV of $60,000, two-thirds of which is includable in John's estate. Jim figures his basis in the property at the date of John's death as follows:

Interest Jim bought with his own funds - ? of $30,000 cost $10,000
Interest Jim received on John's death - ? of $60,000 FMV 40,000 $50,000
Minus: 1/2 of $12,000 depreciation before John's death 6,000
Jim's basis at the date of John's death $44,000

If Jim had not contributed any part of the purchase price, his basis at the date of John's death would be $54,000. This is figured by subtracting from the $60,000 FMV, the $6,000 depreciation allocated to Jim's half interest before the date of death.

If under local law Jim had no interest in the income from the property and he contributed no part of the purchase price, his basis at John's death would be $60,000, the FMV of the property.

Qualified Joint Interest

Include one-half of the value of a qualified joint interest in the decedent's gross estate. It does not matter how much each spouse contributed to the purchase price. Also, it does not matter which spouse dies first.

A qualified joint interest is any interest in property held by husband and wife as either of the following.

• Tenants by the entirety.
• Joint tenants with right of survivorship if husband and wife are the only joint tenants.

Basis. As the surviving spouse, your basis in property you owned with your spouse as a qualified joint interest is the cost of your half of the property with certain adjustments. Decrease the cost by any deductions allowed to you for depreciation and depletion. Increase the reduced cost by your basis in the half you inherited.

Farm or Closely Held Business

Under certain conditions, when a person dies the executor or personal representative of that person's estate can choose to value the qualified real property on other than its FMV. If so, the executor or personal representative values the qualified real property based on its use as a farm or its use in a closely held business. If the executor or personal representative chooses this method of valuation for estate tax purposes, that value is the basis of the property for the heirs.

Qualified heirs should be able to get the necessary value from the executor or personal representative of the estate.