Sale of the Personal Residence After Death

Overview

Upon death, particularly the death of the surviving spouse, the estate executor may need to dispose of the decedent’s personal residence.  When that happens, numerous tax considerations come into play.  There are also some planning aspects to handling the personal residence. 

The sale of the personal residence after death – that’s the topic of today’s post.

Income Tax Basis Issues

Upon death, the executor may face the need to dispose of the decedent’s personal residence.  The starting point to determining any tax consequences of the disposition involves a determination of income tax basis.  If the residence was included in the decedent’s gross estate, the tax basis will be determined in accordance with fair market value as of the date of the decedent’s death under the willing buyer-willing seller test. I.R.C. §1014.  That is based largely on sales of comparable properties, and requires more than a simple market analysis by a real estate agent. 

If the decedent was the first of the two spouses to die, a determination of how the residence was titled at death will need to be made.  For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s share of the residence will be included in the decedent’s estate and receive a basis step-up to fair market value.  Id.  In common-law property states where the residence is owned in joint tenancy between the spouses, the property is treated at the first death as belonging 50 percent to each spouse for federal estate tax purposes.  I.R.C. § 2040(b). This is known as the “fractional share” rule.  Thus, one-half of the value is taxed at the death of the first spouse to die and one-half receives a new income tax basis.  However, in 1992 the Sixth Circuit Court of Appeals applied the “consideration furnished rule” to a husband-wife joint tenancy involving farmland. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992).    The result was that the entire value of the land acquired before 1977 was included in the estate of the first spouse to die. That meant that the full value was subject to federal estate tax, but was covered by the 100 percent federal estate tax marital deduction.  The entire property received a new income tax basis which was the objective of the surviving spouse.  Other federal courts have reached the same conclusion.

If the residence is community property, the decedent’s entire interest will receive a basis step-up to fair market value.  If the residence is held in joint tenancy with rights of survivorship, the decedent’s interest passed by the survivorship designation to the designated survivor.

Loss Potential

If a surviving spouse sells the marital home shortly after the first spouse’s death, the survivor will often realize a loss largely due to the expenses incurred with respect to the sale.  If the survivor realizes a gain, then, the survivor is eligible for the $250,000 exclusion of gain.  I.R.C. §121.  That exclusion is a maximum of $500,000 if the sale occurs within two years of the first spouse’s death.  

Residence Held in Trust

A revocable trust is a common estate planning tool.  If the decedent’s personal residence was held in a revocable trust and passed to the surviving spouse upon the first spouse’s death under the terms of the trust to continue to be held in trust, the house receives a full step-up (or down) in basis to the current fair market value at the death of the surviving spouse.  If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, a loss generally will be a nondeductible personal loss unless the home is first converted to a rental property before it is sold.  This is a key point that may require some planning to allow for rental use for a period of time before sale.

If the residence must be sold by the estate or trust to pay debts or to satisfy cash distributions to beneficiaries, any loss on the sale might be deductible.  That loss could potentially offset other income of the trust or estate, or it could flow through to the beneficiaries.  However, the IRS position is that an estate or a trust cannot claim such a loss unless the residence is a rental property or is converted to a rental property before it is sold. This position has not been widely supported by the courts which have determined that a trust or estate can claim such a loss if no beneficiaries use the home as a residence after the decedent’s death and before it is sold.  It is important to get good tax counsel on this issue.  It’s an issue that comes up not infrequently.

Conclusion

The sale of the personal residence after death presents numerous tax issues.  With a modest level of planning, negative tax consequences can be avoided and helpful tax provisions can be taken advantage of.