Lynn Brenner's Family Finance

What Tax Do We Owe on Inherited House?

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 [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

 

Tax Tips for the Sandwich Generation

You know who you are. You're working fulltime, extending a financial helping hand (and maybe a roof) to your adult kids, and moonlighting around the clock as the co-manager of your parents' multiple health care issues.

In other words, you're an aging baby boomer - a member of the generation right-wing pundits routinely excoriate as lazy and self-indulgent compared with its hard-working predecessors. Uh-hunh.

(In case you haven't guessed, so am I.)

The tax code doesn't provide much relief for the sandwich generation, but many of us don't take advantage of the small breaks that are available. You may find some useful pointers in an article I recently wrote for Reuters.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

'Sweet Spot': The Key 11 Years of Retirement Planning

If you're nearing age 59 or you haven't yet reached age 70, listen up.

You're standing in a window of opportunity -- the 'sweet spot' of retirement planning. Now's the time to take steps to protect your future retirement income from the ravages of annual taxes and market volatility.  For more, see my recent Reuters article "Six Ways to Maximize Retirement 'Sweet Spot' Years".

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

When is the Best Time For a Roth Conversion?

Q: I'll be retiring sometime in 2012. I'd like to take all or a part of my 401(k) and roll it into a Roth IRA. What would I have to pay in taxes to begin with? Could I remove a portion of the Roth IRA tax-free in an emergency? I'll be 64 in 2012. --DH via email

 

A: The amount you transfer from your 401(k) to a Roth IRA is added to your taxable income for the year in which you do the conversion. If you rolled $100,000 into a Roth in 2011, for example, your 2011 taxable income would shoot up by $100,000.

Financial planners say it's often less expensive to do a Roth conversion the year after you retire than while you're still employed.

Your taxable income will be smaller because you'll no longer be earning a salary. What's more, you may be able to claim high deductions from the previous year. (The 2010 state and local income taxes that you paid in 2011 are deductible on your 2011 federal return, for example.) If your deductions exceed your income, you may not even owe any taxes in your first year of retirement, says Robert Schmansky, a Pittsburgh financial adviser. As a result, you might be able to withdraw money from a tax-deferred account like a traditional IRA or a 401(k) plan -- whether you need it to live on or want to roll it into a Roth IRA -- without triggering a tax bill.  

Make an appointment with a tax accountant who can crunch your numbers and advise you on the best way to time your Roth conversion. (One question to discuss with him or her is whether it makes sense for you to do a single conversion, or a series of small annual conversions. Depending on your tax situation, several small conversions may be less expensive.)

As for your second question, yes, the money in the Roth IRA will be accessible tax-free in an emergency. In fact, you'll be able to take a tax-free distribution of the entire amount you rolled into the Roth IRA after you do the conversion.

This important point is often misunderstood. 

The rule is that you can withdraw Roth IRA earnings tax-free after you are 59 and a half years old and have owned the account for five years. What people usually don't understand is that in an ordinary Roth IRA (not a converted IRA) your principal -- i.e., the amount you contributed -- is not subject to that requirement. You can withdraw principal at any time, regardless of your age, without incurring a tax.

The reason is very simple: You've already paid taxes on that money.

In a converted Roth IRA, there is a penalty on funds withdrawn within five years of the conversion -- but only if you're under 59 1/2 years old. In your case, it wouldn't apply, says Barry C. Picker, a Brooklyn tax accountant.

Here's an example. You roll $100,000 from your 401(k) plan into a Roth IRA. Let's say you're in the 15% tax bracket when you do the transfer, so it costs you $15,000 in taxes. We'll also say you can pay that bill from another account, so you're able to deposit the entire $100,000 in the Roth IRA. (If not, you'd only be able to roll $85,000 into the Roth account.)

The very next day, you could take your entire $100,000 deposit out of the Roth IRA tax-free.

But of course you hope you won't have to do that ... because the Roth conversion only makes financial sense if your earnings in the account ultimately exceed the $15,000 tax you paid to do the transfer. That's very unlikely to happen if you must start emptying the Roth account right away. 

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved.