Death and Taxes

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Question:  My father left me his house in Pebble Beach when he died.  He paid $60,000 for it back in 1970.  His attorney had it appraised to determine the value on the date of his death, and it appraised at $1.5 Million.  He made a few improvements, but we have no record of the costs.  I am thinking about selling the house, or maybe keeping it as a rental.  If I sell it do I have to pay income tax on the gain?

Answer:  If your father owned the house when he died, your cost basis under current tax law will be the property’s fair market value on his date of death.  You subtract the cost basis and expenses of sale from the sale price to determine taxable gain.  If the sales price you realize is not more than the date of death value, you won’t owe any tax and you may have a deductible loss because inherited real estate is treated as investment property at the time of inheritance.  For example, if you sell the house at the appraised value of $1.5 Million, and you pay a real estate sales commission of 6%, you will have a loss of $90,000.

If you rent the house, you will be able to depreciate the structure, but not the land, using the stepped-up cost basis.  This depreciation can shelter some of the rental income from tax. 

Regardless of your decision to sell or rent, you are benefiting from a tax law that has been in place for decades because Congress did not think you should pay estate tax on inherited property and then pay income tax on the same property.   This tax benefit is currently being threatened in President Obama’s latest budget proposal.  The proposal would remove the step-up in cost basis, meaning the cost basis of any capital asset you inherit would not be increased to fair market value when the owner dies. 

If these budget proposals were in effect and you sold your father’s house for $1.5 million, your capital gain would be $1.35 million ($1.5 million less his purchase price of $60,000 less the $90,000 sales commission).  Assuming a combined Federal and state capital gains tax rate of 35%, you would pay $472,500 in tax. 

The proposed budget would also increase the current dividend and capital gains tax from 23.8 to 28%.

Question: I heard on the news this morning that President Obama, in his latest budget proposal, is asking Congress to remove the tax benefits of college savings plans.  We have been contributing to 529 college savings plans for our kids.  How would this affect us?

Answer: Not surprisingly, this proposal in the President’s current budget proposal has been drawing a lot of flak.  The President seems to think that college savings plans are primarily used by the wealthiest Americans (more than $200,000 of income by his definition) and sees taxing the withdrawals from these plans as a way to raise federal tax revenues to support increased education tax credits for the middle class.  Whether or not the President’s assumptions are correct is a topic of dispute.  In any case, given the current political environment in Washington, this proposal is unlikely to become law.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to ken@montereypw.com.