The IRS has their own rules for this, that are independent of state rules, while still respecting the rights of community property states. Without wasting time getting into the particulars and using the numbers you provided (of which $126K is a bit off), your cost basis is $126.5K.
-Mom & Dad purchased for $85K. Dad gifted you his share (50%) so you were also gifted 50% of that, which is $42.5K
When dad passed, only mom's share was passed to you. So if the "ENTIRE" property was valued at $168K when she passed in 2007, half of that is $84K. So 42.5 plus 84K is $126.5K. Any gain over $126.5K is taxable income for you.
Since you owned the entire property as a whole for more than one year, then you don't need to worry about determining the amount of short term gain and long term gain. It's all long term gain.
