Widow selling house in CO with large capital gain

[gfunkbigdaddy]

My step-father passed away on 3/1/2023 and my mother has moved to another state to live closer to family. She is selling their (now her) house in Colorado they lived in together for 20 years. As I understand it, she has until 3/1/2025 (2 years from date of death) to sell the house and exclude up to 500k in cap gains. After that, only $250k. The original basis was $300k in 2003, market value when he died in 2023 is $800k, I expect the market value in 2025 to be $850k.

I don't understand what her options are after 3/1/2025 if the house doesn't sell by then. Can she:

1. Take a step-up in cost basis (on his original half of the house) to reduce her tax liability? If so, how long does she have to do that?
2. Or should she considered transferring ownership with a quit claim deed to a family member before 3/1/2025 if the house doesn't sell so she can get the full $500k benefit?
3. Or is her best option to stick with the max $250k benefit?

[tagteam]

Yes, after the 2-year period (per Section 121(b)(4)) she can use the stepped-up basis and there is no time limit (i.e., that does not expire at any point).

[rjs]

Your mother already got stepped-up basis on your step-father's half of the house. She doesn't have to do anything to get it. It's automatic. So her basis is now $150,000 on her half, plus $400,000 on your step-father's half, which is a total of $550,000. If she sells the house for $850,000 her gain will be $300,000. And as tagteam said, the stepped-up basis does not expire.

Don't forget that she can add to her basis the cost of any improvements that they added to the house. Selling expenses, such as a broker's commission will be subtracted from her gain.

It's not clear what you mean by "transferring ownership" to a family member. If the family member does not pay for the house, the exclusion will be lost.

[tagteam]

Transferring title to a family member will not work unless she receives full fair market value for the house and the transfer is a legitimate sale. 

That would either be considered a sham transaction or a part gift/part sale.

[Opus 17]

I don't understand #2, but it smells funny.

Is she going to legitimately sell to a family member for full price?  That's fine.  Then the family member sells the house, and might have a small gain or small loss.  But the family member won't get any exclusion, and will probably have significant closing costs.  If it would not be a legitimate sale at full price, that sounds like a legal problem down the road.   

There's no reason to be afraid of taxes, it's just one factor of many.  Since her basis is at least $550,000, the difference between selling before or after 3/1/25 is, at most, $10,000 of capital gains taxes.  If she really doesn't want to pay any tax, drop the price, get a faster sale, and take less profit.  (But why drop the price $50,000 in order to save $10,000?)

And don't forget the basis adjustments from improvements and selling expenses. 

[Opus 17]

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@rjs wrote: Don't forget that she can add to her basis the cost of any improvements that they added to the house. Selling expenses, such as a broker's commission will be subtracted from her gain.

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It may be worth mentioning that, because of the step-up, your mother can only adjust her basis by half the cost of improvements.  For example, suppose they remodeled the kitchen in 2010 for $50,000.  Mother's basis becomes $150,000+$25,000 = $75,000, and the father's basis is the same.  When her spouse died, your mother received the full step up of $400,000 on his half, which "absorbs" the improvements.  Her final basis would be $575,000 in this example, showing how she add half the cost of any improvements to her basis, not the entire cost (for improvements made before 3/1/23, of course.  She gets a full adjustment for improvements made after 3/1/23.)

[tagteam]

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@Opus 17 wrote:

Is she going to legitimately sell to a family member for full price?  That's fine.  Then the family member sells the house, and might have a small gain or small loss. 

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That could very well present an issue if the "family member" turns around and sells the house shortly after the "sale".

The step transaction doctrine could come into play. The IRS could consider it to be a fraudulent transaction designed only for the purposes of tax avoidance. Not good.

[Opus 17]

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@tagteam wrote:

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@Opus 17 wrote:

Is she going to legitimately sell to a family member for full price?  That's fine.  Then the family member sells the house, and might have a small gain or small loss. 

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That could very well present an issue if the "family member" turns around and sells the house shortly after the "sale".

The step transaction doctrine could come into play. The IRS could consider it to be a fraudulent transaction designed only for the purposes of tax avoidance. Not good.

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Well, I said "full price", which I think avoids your concern, but I agree with your overall point.  If the mother sells the home to a family member for less than full price (let's say $800,000) and the family member flips it for full price ($850,000), that sounds like tax avoidance by the mother.  (Although the family member will owe tax and won't be able to exclude it.)

[tagteam]

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@Opus 17 wrote:
If the mother sells the home to a family member for less than full price (let's say $800,000) and the family member flips it for full price ($850,000), that sounds like tax avoidance by the mother.

Even if the family member pays full price (fair market value) and sells it for the same price the family member paid shortly after the purchase, there is still the issue of the mother claiming the Section 121 exclusion and that could present an issue.