Q: I just read your article in our local paper titled “Parents worry about splitting sale of home,” but it did not answer some questions I’ve had.
My first question is about selling my vacation home. My understanding is I would have to pay taxes on the sale, but if I let my three kids inherit it, my kids would pay no taxes if they sell it quickly. Is this correct?
My second question is what happens if I sold my primary residence to help pay for my medical expenses? Would I be able to keep the gain tax free if the gain was less than $500,000? Is this correct? What happens with taxes if my kids inherit the primary residence? Thanks.
A: Given our mail, we can honestly say that there’s nothing more confusing for our readers than issues relating to real estate combined with inheritance and taxes. Except, perhaps, for quitclaim deeds.
Let’s start with the idea that if you make a profit on the sale of your real estate, the Internal Revenue Service expects you to pay tax on that profit, with some notable exceptions. But, not all real estate is equal to the IRS. Primary residences and vacation or investment homes are treated differently under current tax law.
Let’s start with the sale of your primary home. The federal government gives a huge tax break to homeowners who have lived in their homes for two out of the last five years and have used that home as their primary residence. In this situation, if you sell the home for a profit, you won’t have to pay any federal taxes as long as the profit is less than $250,000, if you’re single, and $500,000, if you’re married.
So, if you sell your home and you fit the requirements of the law, it’s unlikely that you’d have to pay federal taxes on the sale of the home. Now, we can’t go into all of the different requirements and limitations due to space here, but if you have more questions, you can get answers from the Internal Revenue Service at www.irs.gov. (Look for Publication 523 about selling your home.)
On the flip side, when you sell your vacation home, you’ll have to pay federal taxes on any profit you make from the sale. When you own a vacation home or second home for more than a year, the tax on the profit will usually be taxed at a capital gains tax rate. That rate can be as high as 20% plus a 3.8% net investment income tax. You might find that you pay less than this amount, but this should give you a high-end number to think about should you decide to sell the vacation home.
What happens if you simply bequeath your homes to your kids after your death?
If you want to let your kids inherit the homes, your kids will receive the properties from your estate at a value determined at or around the time of your death. Let’s say you purchased a home for $100,000 and when you die the home is worth $250,000. If your kids then sell the home shortly after they inherit it for $250,000, they will pay no tax on that sale. For IRS purposes, your kids would have acquired and sold the homes for the same value, so there would be no tax to pay. This is the tax principle known as the stepped-up basis.
If, however, your kids hold onto the property for a while after your death and later sell it for $350,000, they will have to pay tax on the $100,000 profit. Given that the IRS usually allows heirs to claim the sales price as the value of the home when the home is sold within a year or so of your death, they will pay no federal tax on the profit if the home is sold within that first year but then will pay capital gains taxes on the profit when the home was sold after the first year.
Finally, you mentioned in passing that you might have to sell the home to pay medical expenses. Your decision to sell one of the homes to pay medical expenses shouldn’t change what you owe the federal government in taxes, although it might give you a medical expense deduction on your federal income tax return.
The IRS allows you to deduct medical expenses when those medical expenses exceed 7.5% of your adjusted gross income. Keep in mind that you currently get a standard deduction of $12,550 if you are single, $25,100 if you are married, and $18,880 if you are the head of household.
In addition to federal taxes owed, there may be state taxes owed depending on the size of your estate or the amount of profit from the sale. Your local tax preparer, CPA or enrolled agent will be able to help further.
(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through their website, bestmoneymoves.com.)