Vacation home’s value adjusted at inheritance

Q: I am an 84-year-old trying to wind up his financial affairs to make things simple for my children after I pass away. My wife passed away in 2016 and I lived by myself for five years. I sold my principal residence last year and moved into an independent living facility, and I am now under contract to sell my last significant property, which is a mountain “getaway” property. My wife and I bought the property in 2007 for $240,000 and I will be selling (it) for $539,000. The documents I prepared for the title company include a statement about the use of the property. I checked that I did not use the property as my principal residence, which is true. My broker tells me that I will get a 1099-S reporting the sale proceeds. My broker said he does not know what that means for the taxes I will owe. He is certain I will owe taxes. I assume that I will be allowed to deduct the sales commission and other costs of closing. If that is right, do I then subtract the $240,000 cost? One thing that worries me is I cannot find the settlement statement that shows I spent $240,000, but I am sure that is what we paid. Will the IRS require me to prove this? What happens if I can’t? And will this all be capital gain income?

A: This sale will need to be reported on your 2022 tax return. Because it was a vacation home, you will have to report the gain from the sale as a capital gain on IRS Schedule D.

You will report a sales price of $539,000. That figure will then be matched to the 1099-S that you will receive. The gain is the difference between $539,000 and your tax base in the property.

It is generally the taxpayer’s burden to prove the tax basis. Your concern about the settlement statement would often be an issue. Because your wife passed away after you bought the house, you will not need to prove what you paid for it.

When you inherit property, your tax basis is adjusted to fair market value (FMV) at the date of death. I assume you and your wife kept this house as community property until her death.

You inherited your wife’s community share of the property when she passed away. The tax law has a special basis rule for community property that allows a tax basis adjustment to FMV for the entire property.

This means that your tax base becomes the FMV of the house in 2016 at the date of your wife’s death. This is so regardless of what you paid for the property in 2007.

The costs of sale listed on the 2022 settlement statement will be added to this 2016 adjustment to the tax base.

Selling costs are those incurred because you sold the property. Prorated property taxes charged to you do not count because you are liable for the taxes whether or not you sell.

This analysis does not solve your basic worries. It just means that the issue changes from what you paid in 2007 to what the property was worth when your wife passed away.

Just to be sure we’re on the same page, let’s say that the house was worth $425,000 when your wife passed away, and that the selling costs are $40,000. This would make your tax base $465,000.

Your tax gain in 2022 would then be $74,000 ($539,000-$465,000). This gain is much lower than if you had been forced to use the 2007 purchase price.

As a single taxpayer, your capital gains rate will probably be 15% for federal tax purposes. The rate is zero up to $41,675 of taxable income.

If you have other income in 2022 that reaches $41,675 after the standard deduction or itemized deductions, your capital gains rate will be 15%.

I just made up the FMV in the example above. You may want to ask your broker for help in estimating the value as of the date of your wife’s death.

However, the FMV basis adjustment will eliminate a lot of the tax burden that you might have been expecting.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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