Understanding Capital Gains After a Spouse’s Passing

When a loved one passes away, managing finances becomes an essential task, and one of the most significant decisions may involve the family home. For surviving spouses, selling a primary residence can trigger tax implications, particularly capital gains tax. Thankfully, the IRS provides a special 24-month rule that can help mitigate this tax burden.

This article will explore the fundamentals of capital gains, the benefits of the 24-month rule for surviving spouses, and practical strategies to minimize taxes during a home sale.

What Are Capital Gains and How Are They Taxed?

Capital gains occur when you sell an asset for more than you initially paid for it. For example, if you bought your home for $300,000 and sold it for $800,000, the capital gain would be $500,000. This gain is subject to federal taxes, which vary based on your income level and how long you owned the asset.

When it comes to your primary residence, the IRS offers a valuable exclusion:

• Married couples filing jointly can exclude up to $500,000 of capital gains.
• Single filers or those filing as a surviving spouse beyond two years can exclude up to $250,000 of capital gains.

The exclusion means you only pay taxes on gains exceeding these thresholds.

The 24-Month Rule for Surviving Spouses

For married couples, the $500,000 exclusion is a significant benefit. However, if one spouse passes away, the surviving spouse’s exclusion drops to $250,000—unless the home is sold within 24 months of the spouse’s death. This rule enables surviving spouses to maintain the full $500,000 exclusion during this period, allowing more flexibility during a challenging time.

Key Requirements for the 24-Month Rule

1. The home must have been your primary residence for at least two of the last five years before the sale.
2. You must sell the home within 24 months of your spouse’s death.
3. You must not have claimed the capital gains exclusion on another property in the past two years.

Failing to sell within the 24-month window means your exclusion reverts to $250,000, potentially exposing you to a significant tax burden.

Real-Life Examples

Scenario 1 – Selling Within the 24-Month Period

Jane and her husband, John, purchased their home 20 years ago for $250,000. Over the years, they invested $50,000 in home improvements, bringing their cost basis to $300,000. After John’s passing, Jane decided to sell the home for $800,000.

• Capital gain: $800,000 – $300,000 = $500,000
• Exclusion: $500,000 (because Jane sold within 24 months and qualifies for the married filing jointly exclusion).
• Taxable amount: $0

Scenario 2 – Selling After the 24-Month Period

If Jane waits longer than two years to sell, her exclusion drops to $250,000.

• Capital gain: $800,000 – $300,000 = $500,000
• Exclusion: $250,000 (single filer limit).
• Taxable amount: $250,000

In the second scenario, Jane would owe capital gains tax on $250,000, significantly reducing her net proceeds from the sale.

How Stepped-Up Basis Can Help

When a spouse passes away, the cost basis of the home may “step up” to its fair market value as of the date of death. This adjustment reduces the taxable capital gain when the property is sold. The stepped-up basis can apply to the entire property or half of it, depending on the state and how the property is owned.

Example of a Stepped-Up Basis

If Jane and John’s home was worth $600,000 at the time of John’s death, the cost basis increases to $600,000. If Jane sells the home for $800,000 within two years:

• Capital gain: $800,000 – $600,000 = $200,000
• Exclusion: $500,000 (within 24 months).
• Taxable amount: $0

The stepped-up basis minimizes the gain and allows Jane to keep more of the sale proceeds.

Frequently Asked Questions

1. What happens if the home is in a trust?
If the home is held in a trust, the rules can vary. Consult a tax advisor to determine how the capital gains exclusion and stepped-up basis apply.

2. Can I use the exclusion for a second home or investment property?
No. The capital gains exclusion only applies to a primary residence where you’ve lived for at least two of the last five years.

3. How does remarriage affect the exclusion?
If you remarry, you may qualify for the $500,000 exclusion with your new spouse, provided you meet the requirements for the exclusion.

Strategies for Minimizing Capital Gains Taxes

1. Sell Within the 24-Month Window
   If possible, plan to sell your home within two years of your spouse’s passing to maximize the $500,000 exclusion.
2. Document Improvements
   Keep records of significant home improvements, as these increase your cost basis and reduce taxable gains. Examples include adding a deck, upgrading appliances, or installing a new roof.
3. Consider a 1031 Exchange
   If you plan to reinvest in another property, a 1031 exchange can defer capital gains taxes by rolling the proceeds into a similar property.
4. Consult a Tax Professional
   Every situation is unique. A tax advisor can guide you through the complexities of capital gains rules and exemptions.

The Importance of Timing and Planning

Selling a home after losing a spouse is a deeply personal decision. The 24-month rule provides an opportunity to preserve your wealth during a transitional period, but it requires careful planning and timely action. Understanding your options, leveraging the stepped-up basis, and working with financial professionals can help you make the best decision for your future.

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🧑‍💼Authored by Brent Meyer, founder and president of SafeMoney.com, with over 20 years of experience in retirement planning and annuities.

The information provided in this article is for informational purposes only and should not be considered as financial, legal, or investment advice. Readers are encouraged to consult with a qualified financial advisor or other professional to discuss their specific financial situation and needs before making any investment or retirement planning decisions. Safemoney.com and the author do not assume liability for any financial decisions made based on the information in this article.