2 Key Home-Sale Tax Rules for Surviving Spouses

Many widowed clients live in homes they have owned for decades. In spite of the recent real estate crisis, these homes have still appreciated dramatically from their original purchase price. As they prepare to downsize or relocate to a retirement community, many are afraid of the taxes due on the sale of their marital home.

Understanding the rules on the taxation of gain from the sale of a primary residence can help you to project the real tax cost of a sale. The basic steps are to determine if the sale itself qualifies for the exclusion and if the ownership and residency requirements have been met. Note that a mobile home or even a houseboat can all count as a residence.

Does the Sale Qualify? In order for the sale to qualify for the exclusion of $250,000 toward gain ($500,000 if married filing jointly), the following must be true:

1. You owned the home and used it as your primary residence for two of the past five years.
2. You did not acquire the home through a like-kind exchange (also known as a 1031 exchange) during the past five years.
3. You did not claim any exclusion for the sale of another home that occurred during a two-year period.

There are certain situations that may allow clients to qualify for a partial exclusion such as a work- or health-related sale or move. See IRS Publication 523 for details.

Meeting the Ownership Requirement If you owned the home for any 24 of the past 60 months, you have met the ownership requirements. If either spouse meets this requirement, both spouses are considered to have met them. For widowed spouses, if the home sale occurs within two years of the date of death and the surviving spouse has not remarried, then the widowed spouse can count any time the deceased was an owner as time they were an owner.

Meeting the Residency Requirement Unlike the ownership requirements, normally each spouse must individually meet the residency requirement of the home being their primary residence for 24 of the past 60 months. However, for widowed spouses, if the home sale occurs within two years of the date of death and the widowed spouse has not remarried, they can count any time their deceased spouse was a resident as time they were the resident.

If all these requirements are met...

1. home sale qualifies for the exclusion,
2. home sale is within two years of the date of death,
3. widowed spouse has not remarried, and
4. widowed spouse meets the ownership and residency requirements

... the surviving spouse can still use the full $500,000 exclusion toward gain from the sale of their marital residence.

When the Timing Doesn't Work If the widowed spouse sells the home more than two years from the date of death, does she have to pay tax on all the gain over her remaining $250,000 exclusion? Not necessarily. If the home was owned jointly, then there is a step-up in basis for the deceased spouse's share of the home.

Let's assume the home was purchased for $200,000 in 1980. Both spouses owned and continuously lived in the home. They added $100,000 in capital improvements before his death. (See IRS Pub 523 for information on what counts as capital improvements, but generally it is anything expected to last more than one year, excluding general repairs and maintenance.)

Assume the husband died in 2012. At the time of her husband's death, the widow wisely had the home appraised, and its fair market value was determined to be $725,000. (Most people do not have their homes appraised upon the death of a spouse; usually a real estate tax assessment can be used to determine value, but this may be less than an appraised value.)

Later, in 2016, the widow decides to move closer to her family. The home sells for $750,000, and she paid $45,000 in realtor commissions.

To calculate the adjusted cost basis of the home, consider the following: The wife inherited the husband's share of the home when he died at a stepped-up cost basis of $362,500 (one-half of the appraised value of $725,000 at the time of his death). The adjusted cost basis is then the sum of wife's own cost basis of $100,000 (one-half of the original purchase price) + $362,500 stepped-up cost basis inherited from her husband + $45,000 (realtor fees) + $100,000 (capital improvements) for a total adjusted cost basis of $607,500. The home sold for $750,000, for a gain of $142,500 on the adjusted cost basis, which is below the $250,000 exclusion, so there is no taxable gain. (Note that in community property states, there is a full step-up in basis on the first death.) There are many other factors that affect the taxable gain such as having taken deductions for business use of your home or rental income, etc.

It is important to remember to step-up a deceased spouse's interest at the time of sale. Even in the case of an investment property sold years after the death of a spouse, the ability to step-up the basis for the deceased spouse's share should not be overlooked.