Sale of a Residence After Death – Part II
Originally published in the Cedar Street Times
April 5, 2013
Two weeks ago we discussed the sale of a personal residence after someone passes away when held as joint tenants or community property. We also discussed the concept of a cost basis step up (or down) to the current fair market value at death as it relates to joint tenancy, community property, and tenancy in common. If you missed this article you can find it on my website at www.tlongcpa.com/blog. This week we are going to discuss what happens when a sole owner or tenant in common passes away and the house or fractional interest in a house goes to their trust or estate.
Often children are tasked with figuring out what to do with mom or dad’s house after the second spouse passes. Names like executor, executrix, and trustee get thrown around and sometimes you get to know your accountant and attorney better than if you had gone on a fishing trip together! After death, the house typically become part of the estate if there was no trust in place, and if there was, then it becomes part of an irrevocable trust that has the task of winding up affairs and distributing the assets to the beneficiaries (or trusts for the beneficiaries).
If the surviving spouse held the house as a sole owner or in his or her revocable trust before death, the house receives a full step-up (or down) in basis to the current fair market value at death. If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, you often will have a loss due to the real estate commissions and other sales expenses (or perhaps even a market decline between date of death and the sale as we saw so often over the past five years). This loss, however, will generally be a nondeductible personal loss unless you first convert it to a rental property, and then sell it later.
If, however, it is decided the house needs to be sold while it is still in the estate or trust in order to pay debts or to distribute the proceeds to various beneficiaries, you may have a case to take a deductible loss on the sale of the property (which would offset other taxable income in the estate or trust, or perhaps flow through to the beneficiaries reducing their personal taxes). Fair warning, the IRS and the courts disagree on this issue!
The IRS has taken the position that even a trust or estate cannot take a loss unless it is a rental property or converted to a rental property and then sold. However, this conflicts with some of the instructions they provide regarding capital assets held by trusts and estates. The courts, on the other hand, have held that a trust or estate does not hold personal assets, and thus is allowed to take a loss on the sale of what used to be the decedent’s personal residence as long as no beneficiaries live in the property in the interim. There are other issues to consider here, but in the right circumstances, strategic planning could create some large tax savings.
If a tenant in common passes away, his or her ownership percentage receives a step in basis to the current fair market value and the interest flows through to the estate or trust. Similar results would occur as those just discussed for sole owners. It is less common to find someone holding a personal residence as a tenant in common, especially with unrelated people. It also comes with other, more complicated issues, since fractionalizing ownership in a house diminishes the value – basically, who wants to buy a house with other people you don’t know? In all cases after someone passes away, date-of-death appraisals are requisite, and you may need specialized appraisers for fractional interest properties.
This really just scratches the surface of the issues you can encounter, and it is always best to find a CPA and attorney team that is equipped to handle these issues appropriately.
IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.
Travis H. Long, CPA, Inc. Blog 
Dear Travis, Thank you for your wonderful write up about the sale of a residence after death. Your topic is so timely; it’s like you had me in mind when you wrote it. Anyway I’m delighted that you handled my taxes this year and we’ll see if I get any comments from the IRS. Thanks again!
Thanks very much for the comments, Chris. It is a pleasure working with you, and I hope the articles will continue to be useful.
Mr. Long,
Your are doing a great job of informing us, but there is a twist to my question.
Our primary residence (our only real estate) was originally in joint tenancy with my wife. We transferred ownership to her revocable trust a few years ago primarily for tax purposes. If she predeceases me, the house will be transferred to a “Family” trust of which I am the trustee and beneficiary. It is expected that the house would be the only asset in the Family trust.
Given the above situation, is there any option except selling the house to pay real estate taxes, cover maintenance costs, etc.
Thank you very much.
Hi John,
Without reviewing the trust documents, it is difficult to know for sure. Most trust documents have provisions written into the documents that allow the beneficiary to live in the property and allow the beneficiary to pay the real estate taxes and maintenance. If you rent it out, you will of course have income generated to pay those expenses.
There are cases, however, where the documents are not drafted well, or have not been reviewed recently and circumstances have changed creating very difficult situations. In these cases, a loan to the trust can be made (often a personal loan) which becomes a debt the trust has to settle at the time the home is sold or the trust is terminated. Loans like this have to pay or accrue interest. Commonly the Applicable Federal Rates (AFR) are used to avoid scrutiny.
I hope this helps.
Hi Mr. Long,
What a great article! Thank you! I wonder if I may also pose a twist… My stepfather passed away first, then my mother. The irrev trust stated that the house was to be split 50/50 between me and my step-sibling; however, I was allowed to live in it (paying all interest, taxes, insur, etc. myself). My life estate would terminate upon my death or when I no longer used the house as my principal residence. After 10 years of living in the house, I chose to move to a new principal residence, so the house was sold recently. The appreciation on the house since my mother died in 2004 was minimal, and thus, after closing costs, there is a loss on the sale. I understand that I will not be able to take the loss on my taxes, since I used the house as my princ residence, but what about my step-sibling’s half? Would that be a deductible capital loss on their return?
Thank you!
Hi Sharon,
Thanks for the post. I have had this issue come up before. You are correct that your ability to take a loss would be eliminated. Regarding your step-sibling’s half, it is questionable. There are no hard and fast provisions in the code or regs. that would say yes or no when specifically talking about a beneficiary that did not live in the property, and you would be hard pressed to find court cases exactly on point. That said, when you gather everything that is out there regarding the issue and the intent, it seems that it would be a logical conclusion that if there was no benefit to the step-sibling that the step-sibling should be able to take a loss on his or her portion. I did have a tax attorney opine on a similar situation and she came to the conclusion that she felt it should be allowed. But nothing is guaranteed. Filing an 8275 would be a way to protect from penalties if incorrect, but it is also kind of like raising a flag that says, “Hey look here!” Unfortunately, tax law is not always black and white! Best of luck.
OMG I’m so confused. Mom had a revocable trust, sister and I both co trustees and co-beneficiaries. House is being sold for substantial increase from basis of death 15 years ago. Who pays taxes? trust or beneficiaries? Sister recently been living in house and wants marital tax deduction. I’m in highest bracket. Sister trying to distribute trust before sale. Trust says “pay taxes and closing costs and distribute evenly ” What to do? We live in California.
Hi Sharna,
Well, you definitely need to sit down with a CPA that understands trust taxation, and possibly talk with the estate planning attorney that handled the estate. I can’t really answer the questions because we would have to review the trust documents and understand the situation. If her spouse was still living after her death, perhaps this is a bypass trust you are referring to, in which case it wouldn’t distribute until the death of the surviving spouse. If there was no spouse remaining, then generally speaking, most trusts are written to distribute the assets out after death as soon as practicable. So that would have been 15 years ago! It sounds like there would be gain since the basis most likely would have been established at her death (unless it was in a bypass trust of a spouse that passed earlier, in which case it would have been established at his death.) Typically, if you sell an asset in the final tax year of a trust, the gains flow out to the beneficiaries and are taxed on their returns. If it is not the final tax year, the gains will typically be taxed to the trust instead. A trust is taxed at the highest rates after it hits around $12K in income, unlike an individual which is in excess of $400K, so generally people try to structure things so the gains are pushed out to the individual level. A marital deduction has to do with filing a 706 for estate inheritance tax (not income tax), but that would have had to have been filed within 9 months of death if the assets were over the estate tax exclusion at that time. You need to find a CPA in your area to discuss these things. Best of luck!
Thank you so much for the reply! No surviving spouse, all estate taxes paid when mom died. Family home in trust so kids could use it. Time to sell 15 years later. Should we distribute into our names and pay (about 800K of gain) or have trust sell and pay? Since sister has been living there can she take $500K marital deduction?
If the house is sold in the final tax year of the trust (meaning everything else is distributed except for perhaps a reserve for unknown expenses or audits that doesn’t generate over $100 of income in a year), then if you sell in the trust, the gain will generally pass out to each beneficiary and be taxed on their returns via a trust K-1. This might be easier than having multiple people report the sale and hope that they all get their shares reported properly. The sister living in the property should be eligible for a $250K section 121 exclusion on the gain from sale of a principal residence if she lived there for two out of the last five years as her primary residence on her part of the gain. If she had a spouse and he lived with her, then the exclusion is $500K for married filing jointly. (This is not called a marital deduction.) Again, you will want to find someone experienced with trust taxes to prepare these returns for you and review the specifics of your situation, to ensure these general rules apply in your case.