Widows, Do You Have to Pay a Capital Gains Tax If You Sell Your House After the Death of Your Spouse?September 27, 2016 • By Ginita Wall, CPA, CFP®
If your husband has recently passed away, you may decide it’s time to sell your home. Maybe it holds too many sad memories, or it’s just too big for you to handle on your own, or you simply want to live closer to your children.
Whatever your reason, if your house has increased in value over the time that you’ve owned it, then you might worry that selling your house will set you up for a big tax bill from Uncle Sam, thanks to capital gains tax.
A Quick Review of Capital Gains
Whenever you sell an asset, such as a home, for more than you paid for it, the difference is the capital gain. So, let’s say that you purchased your home in 1992 for $300,000 and today that same home is worth $600,000. (Good job!) If you sold the home for $600,000, your capital gain would be $300,000.
It should come as no surprise to you that Uncle Sam wants to take his share of your newfound wealth. Depending on your current tax bracket, you could be asked to pay a capital gains tax of 0% – 20% on the capital gains from your home’s sale.
Before you start writing your congressperson in outrage, there are ways that you can avoid or at least dramatically lower your capital gains tax burden. Let’s look at four ways to save you some major money.
The Capital Gains Tax Exemption
The first and easiest way to lower your capital gains burden is to take advantage of the capital gains tax exemption. For singles, the current exemption is $250,000. That means that the tax won’t apply to the first $250,000 of your capital gains.
This is great news if your house hasn’t appreciated more than $250,000. However, many seniors have lived in their homes for decades, which means the property could have increased significantly in value since they first purchased the house.
Sticking with our original example, if you sold your home for $300,000 more than what you bought it for, you would face capital gains taxes on $50,000 ($300,000 – $250,000).
The capital gains tax exemption only applies if you:
- Are selling your primary residence,
- Have owned your home for at least two years,
- Have lived in your home for two of the past five years
Exclude Home Improvements
The government lets you deduct money that you’ve invested into your home from your home’s sale price when you report capital gains. For example, let’s say that you spent $50,000 on a kitchen remodel in 2005 and then added a granny flat on the property for $75,000 in 2014. In total, you’ve spent $125,000 on major home improvements, which you can deduct from the sale price of your home.
Even though your home sold for $600,000, in essence, it really sold for $475,000 ($600,000 – $125,000). Now, the capital gain on your home is only $175,000 ($475,000 – $300,000), which is within the capital gains tax exclusion. In this scenario, you wouldn’t have to pay any capital gains on your property.
Low Income Tax Bracket
The percentage of the capital gains tax you will face when you sell your home will depend on your yearly income, including the capital gains. Here is how the taxes on income break out for single individuals in 2016. (These numbers will change from year to year):
- $0 – $37,650 in yearly income = 0% capital gains
- $37,650 – $415,050 in yearly income = 15% capital gains
- $415,050+ in yearly income = 20% capital gains
As you can see here, as long as you keep your income below $37,650, including capital gains, you won’t have to worry about capital gains taxes at all. If you are earning $50,000 this year but are planning to retire next year, if you have taxable capital gains, it might be worth it to wait until next year to sell your home when you’ll be earning far less and part of your capital gains will be taxed at a lower rate, or not at all.
Step-Up Basis After the Death of a Spouse
As a recent widow, you have one more card to play to beat capital gains tax. In all likelihood, you and your husband owned your home jointly (both of your names were on the deed) or there was a built-in right-of-survivorship. What this means is that when your husband died, his half of the home went to you.
Something else happened during that transfer that most homeowners don’t realize. Your husband’s half of the home transferred to your ownership on a stepped-up basis. When he died, his portion of the house updated (or stepped up) to the current fair market value of the home.
In our example, you purchased your home with your husband for $300,000. Let’s say that on the day your husband died, your home was worth $550,000. When his half of the home transfers to you, it isn’t worth $150,000 (half of your original purchase price); rather it is worth $275,000 (half of the current fair market value of $550,000). When you sell your home next year for $600,000, the capital gain is NOT $300,000. It is $175,000. How did we come up with that number?
Your half of the house is still at its original tax basis of $150,000 (half of the original $300,000 purchase price), but your husband’s half of the house stepped up to $275,000 when he died (half of the house’s value on the day he died of $550,000). Add $150,000 to $275,000, and you get $425,000 as the tax basis of your home. Subtract $425,000 from the $600,000 sales price, and your capital gain on the sale is $175,000.
That’s a lot of math, but the point is that $175,000 is below the capital gains tax exemption, which means you won’t have to pay any capital gains tax!
Many widows do not know about this rule, and so they don’t report the stepped-up value from their husband’s portion of the house when they sell the house. Don’t make this mistake. It could mean the difference between paying a big capital gains tax on the sale of your house or paying nothing at all!