A number of our Relaxing Retirement members are contemplating selling their homes right now which has led to many discussions about the taxes they’ll potentially owe.

This certainly makes sense. When you were younger and you had a family, having a lot of space in your home made sense.

Multiple bedrooms and bathrooms, a finished basement, a big yard, etc.

However, now that the kids are out on their own and you’ve moved into the “retirement” phase of your life, your big house, and all the physical responsibility that comes along with it, is not as appealing as it once was.

Should you sell it and move into a home that is more suitable to your current lifestyle?

One of the stumbling blocks to moving forward is not knowing what the tax implications will be if and when you sell your home vs. keeping it and passing it on to your children.

This is a very important subject with a wide array of possible outcomes, so let’s walk through a brief example to cover all the bases.

Kevin and Mary

Let’s assume for a moment that we have a couple, Kevin and Mary, who are now 70 years old.

They have three children, all of whom are married.

Kevin and Mary purchased the home that they now live in back in 1984 for \$300,000. Back then, it seemed like all the money in the world, but it was worth it because it was a great house in a family neighborhood.

Right before they retired, they paid off their mortgage in full which included a second mortgage that they had taken out to help with college tuitions.

Today, because they purchased their home in a very nice town, they’ve been told by a local realtor that their home is currently worth \$1,250,000.

Hard to believe!

Tax Implications

If Kevin and Mary decide to sell their home right now, what are the tax implications?

What if they keep their home and the kids inherit it?

To understand what the implications will be, you have to become familiar with the term “cost basis”.

Cost basis is a “tax” term which equals your total cost in an asset like a home.

In Kevin and Mary’s case, this starts with their purchase price: \$300,000.

If they made permanent home improvements over the last 31 years, this would add to their cost basis.

In this case, let’s assume that Kevin and Mary made \$150,000 worth of improvements over the years, including a big addition and a swimming pool.

This now brings their cost basis up to \$450,000.

If Kevin and Mary sell their home and walk away with \$1,185,000 (after paying their real estate broker), they may exclude their “cost basis” or \$450,000 from capital gains taxes, thus leaving \$735,000 subject to capital gains tax.

Capital Gains Tax Exclusion

Several years back, Congress passed a law that allows individuals to exclude \$250,000 from the proceeds of the sale of your home, or a combined \$500,000 if you’re married and own the property jointly.

So, in addition to being able to exclude their cost basis from taxes, Kevin and Mary may also exclude another \$500,000.

To summarize, if they sell their home for \$1,250,000, pay their realtor and walk away with \$1,185,000, \$950,000 is excluded from capital gains taxes.

To arrive at \$950,000, we take their cost basis of \$450,000 (purchase price and upgrades), and their federal capital gains exclusion of \$500,000.

\$235,000 (the difference) is then subject to capital gains taxes which are currently either 15% or 20% on the federal level. And, at higher income levels with the medicare surtax, add another 3.8% if your income is above \$250,000. And, if you happen to live in Massachusetts, add another 5% tax.

In Kevin and Mary’s case, assuming their other income placed them in the 20% capital gains tax bracket, they’d owe approximately \$58,750 in capital gains taxes if they sold their home today.

Step-Up in Basis

This changes dramatically, however, if Kevin and Mary decide to keep their home and pass it to their children at their death.

When you pass away, the cost basis in all your assets “steps up” to your date of death value!

This is significant.

In Kevin and Mary’s case, if the value of their home at their death was \$1,285,000, and their children sell their home soon after their deaths, \$1,285,000 is excluded from the sales price as far as capital gains taxes are concerned.

In other words, the kids would pay no capital gains taxes if they sold their house for that same amount.

That’s a \$58,750 difference!

As a side note, if the kids keep the house for a few years and later sell it for \$1,450,000, they’d owe capital gains tax on the growth since the date of their parents’ death, or \$200,000.

The Lesson