Q: My mom had a house with a life estate. My three brothers and I are on the deed.
My mom passed away on May 4th 2012. Is it true that we inherit her house at its market value, and the sale proceeds when we sell it will be tax-free for us? And is it also correct that there will be no federal tax on my mom's estate unless it's worth more than $2 million, and no New York state tax unless it's worth more than $1 million? What about capital gains tax? -- BS via email
A: You're asking questions about two entirely different categories of tax. Estate taxes are those levied on inherited assets. Capital gains taxes are an income tax levied on your profit when you sell an asset for more than you paid for it.
Let's start with the simple stuff. In this case, it's estate taxes.
In 2012, federal estate taxes are levied only on estates worth more than $5 million, and New York State's estate tax applies only on estates worth more than $1 million. So if your mother's estate was worth $5.5 million, $500,000 of it would be subject to federal tax and $4.5 million of it would be subject to New York tax.
Clear so far? Then let's talk about capital gains.
The basic tax rule is that when you inherit a house, you receive it at its market value, which means when you sell it you're taxed only on the sale proceeds above that market value. But if you receive a house as a gift during its owner's lifetime, you receive it at its original cost -- i.e., what the original owner paid for it. That leaves you with a much higher tax bill when you sell the house.
Sometimes people assume that in a situation like yours, the second rule applies. That's not so!
Your mother gave the house to you and your siblings during her lifetime, but she retained a life estate -- i.e., the right to live there until she died.
If she had given you the house outright, you would be taxed when you sell it exactly as she would have been taxed: you'd owe a capital gains tax on the difference between the sale price and her original cost plus any capital improvements she made. If you sold the house for $1 million, for example, and her original cost plus improvements was $60,000, you would owe tax on $940,000.
But thanks to her retained life estate, you inherited the house at its market value at the time of her death. As a result, when you sell it you'll owe taxes only on the difference between the sale price and that market value. If the house was worth $1 million when she died and you sell it for $1.2 million, for example, you'll owe tax on $200,000.
Every time I write about this, I get at least one email challenging me, so here are the citations that explain why you inherited the house at its market value:
Section 2036 of the Internal Revenue Code says that when you retain a life estate in a house, the total value of the house is included in your estate when you die. Ergo, your mother's house was included in her taxable estate. (This is true whether or not the estate actually incurred estate taxes.)
Section 1014 of the Internal Revenue Code says that your heirs receive what is included in your estate -- with a few specific exceptions that don't include life estates -- at its 'stepped-up' market value.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.