How would capital gains be calculated on the sale of two houses in AZ (community property state) within two years of the death of a spouse?

[kritter-k]

Would there be any exclusion of capital gains for either home, and would there be a step-up in cost basis for the second house like there would be for the first home? Furthermore, would selling the houses in the same year as the spouse’s death, when the widow would still have a tax-filing status of “married filing joint,” be advantageous?

Also, if the proceeds from the sale of both houses were used to purchase a new home in CO, could a 121 home sale exclusion (for the primary home) and/or a 1031 exchange (for the second house) be used to defer capital gains?

For example, the primary home was bought in 2010 for $220,000 and $140,000 worth of improvements were made for a total cost of $360,000. The house’s appraised full fair-market value at the time of the spouse’s death was $502,000.

The second house was bought in 2010 for $226,000, and $76,000 worth of improvements were made, for a total cost of $302,000. The house’s appraised full fair-market value at the time of the spouse’s death was $468,000. The widow’s parents lived in the second home rent-free but paid the property taxes, the property insurance, and the HOA dues. No deductions were ever taken for the house and the widow and her spouse I never lived in the second house.

[rjs · Accepted solution]

Capital gain is the selling price minus the basis. If the home was held as community property, the entire property gets stepped-up basis to the fair market value on the date of the first spouse's death. So the gain on the "primary home" would be the selling price minus $502,000. The gain on the second house would be the selling price minus $468,000. (This is assuming no additional improvements were made between the first spouse's death and the sale.)

The "primary home" would probably qualify for the exclusion of gain. If sold within 2 years of the first spouse's death, provided that the surviving spouse has not remarried, the maximum exclusion would be $500,000. After 2 years it would be $250,000 (assuming the requirements for the exclusion are still met). Selling in the year of death makes no difference. The second house would not qualify for any exclusion of gain because it was never the primary home of either spouse.

Section 121 does not defer the capital gain, it permanently excludes the gain from tax, up to the amount of the exclusion. There is no longer a provision in the tax law that allows capital gain on a primary home to be deferred if you use the proceeds to buy a new home. That provision was eliminated in 1997.

A 1031 exchange is only for business property. Neither of the two homes that you describe would qualify for a 1031 exchange.

Community property also affects reporting of the property on the estate tax return, if one is filed. If you are filing an estate tax return you should consult a tax professional. You cannot file an estate tax return (Form 706) with TurboTax.

[kritter-k]

Thank you so much for the detailed reply rjs. You cleared up all my questions!

[rjs]

@kritter-k 

There's one other consideration that I forgot to mention. If you sell soon after the spouse's death, the selling price might be not much more than the value on the date of death. With a broker's commission and possibly other selling expenses, you might actually have a small loss rather than a gain. But you cannot claim a loss on property that was for personal use. (Having relatives living in one of the houses is personal use.) You might still have to report the sales, but for the sale of your personal home or a second home the net loss shown on your tax return will be adjusted to zero. That means, of course, that there is no tax, and the exclusion of gain does not apply.

[kritter-k]

Thanks for the additional info!