When a Husband and Wife Jointly Own a Home: Understanding the Step-Up in Basis and Capital Gains Exemption
Imagine a scenario where a married couple owns a home that appreciates in value by $500,000. If one spouse passes away, leaving the other as the sole owner, what happens to the tax basis of the property? Does the surviving spouse receive a full step-up in basis, or are they limited to a $250,000 capital gains exemption when selling the property?
To answer this question, we need to delve into the rules surrounding both the step-up in basis of an inherited asset and the capital gain exclusion on the sale of a primary residence. These rules operate independently of each other, so both apply in this scenario.
In finance, the term “basis” refers to the original purchase price of an asset. This basis serves as the starting point for calculating taxable gains. When an asset is inherited, its basis is reset to its market value at the time of the original owner’s death, a process known as a step-up in basis.
In the case of a primary residence, the tax code allows individuals to reduce or avoid capital gains tax on its sale, provided they’ve lived in it for two of the previous five years. This tax break, known as the Section 121 exclusion, allows individuals to exclude up to $250,000 of gains from the sale of a primary residence, while married couples filing jointly can exclude up to $500,000.
To illustrate how these rules apply, let’s consider an example. Suppose a couple owns a home with a basis of $300,000, which appreciates to $500,000 by the time one spouse passes away. The surviving spouse receives a step-up in basis, which depends on whether they live in a community property state or not. In a community property state, the surviving spouse receives a full step-up in basis, while in a non-community property state, they only receive a step-up in basis for half of the property’s appreciation.
After determining the stepped-up basis, the surviving spouse can calculate the taxable gain if they were to sell the property. They would only owe capital gains tax on the portion of the gain that exceeds the Section 121 exclusion.
In our example, if the couple lives in a community property state, the surviving spouse’s basis would be stepped up to $500,000. If they sell the home for up to $750,000, they wouldn’t recognize a taxable gain due to the $250,000 exclusion. Additionally, if they sell the property in the same calendar year as their spouse’s death, they may still be able to exclude the full $500,000 as a married couple filing jointly.
It’s essential to understand the rules surrounding the step-up in basis and capital gains tax exclusion when dealing with inherited property. A financial advisor with expertise in tax planning and estate planning can help you navigate these complex rules and optimize your tax strategy.
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