What To Do With Grandma’s House?
My wife and I just bought our home last summer. It hasn’t even been a year yet, and I’ve already grown attached to having my morning coffee on the deck on warm days, and sipping a drink by the fire on cold nights.
Understandably, it can be difficult to discuss the topic of selling your parent’s or grandparent’s house, especially if they’ve lived in that home for most of their lives.
But this conversation often needs to happen, for one reason or another.
Perhaps you need to pay for your parent’s medical or assisted living expenses. Maybe the house is too big for them to manage any more, and they need to downsize.
Or maybe Grandma is healthy as an ox and would sooner install a gator-filled moat around the house, than to ever move out!
Even if Grandma will feed you to the gators if you even whisper the word “sell”, you may still need to plan for the tax consequences of selling after her sweet soul has flown up to the spirit in the sky.
This article will give you an overview of the tax consequences for both scenarios – selling the house before and after the owner’s death – so that you can make informed decisions as you navigate what can be a stressful process.
Whether you sell the house before or after the owner has passed away, the first question that must be answered is:
1. Who owns the house, and how did they acquire it?
While the answer may seem obvious, ownership can often be a complex legal issue. To definitively answer the question of ownership, you must review the property deed.
Hopefully Grandma kept good records, and her file cabinet is not buried under boxes of family photos and Life magazines, behind a barricade of old air conditioners.
But never fear, deeds are a part of the public record, and can often be searched and downloaded for free on the website of your county’s registry of deeds. (Some counties charge a fee.)
The deed will indicate both:
WHO owns the property – was it Grandma as an individual, or was it Grandma’s Living Trust?
HOW did they acquire the property – did Grandma and Grandpa buy the house together, or did Great-Grandma and Great-Grandpa gift it to them, back when milk still cost a nickel?
If the home has been in the family for many years, it’s possible the deed has been changed multiple times – for example, adding children to the deed once they’ve reached adulthood, or removing children after that giant blowout that we will only discuss with our therapist.
If there have been multiple transfers of ownership within the family, you may need to comb through the registry archives and retrieve the deed for each of those transfers, going back to the original purchase when the house was first sold into your family by an unrelated party.
(Hint: each deed should cite the registry book and page number of the previous deed, when the seller/transferor acquired their interest, to help you follow the paper-trail of ownership.)
“Why?” you might be asking. “Why are you making me do this? I am not an investigative journalist!”
The deed – or deeds – will help answer this next critical question, as you plan to sell Grandma’s house:
2. What is the cost basis of the house?
Cost basis is the value used to determine whether there was a gain or loss from the sale, when reporting the sale for tax purposes.
In a straightforward sale with no wrinkles or complications, cost basis would be the original purchase price.
Grandma bought the house five years ago for $300,000 – her cost basis is $300,000. If she sells the house tomorrow for $400,000, she will have a $100,000 capital gain.
But what if Grandma was not the original buyer? What if your deed research reveals that the property has been transferred within the family multiple times?
If the property was transferred by gift – that is, the donor was still living when the property was transferred to the recipient – in this scenario, the donor’s cost basis passes onto the recipient.
Great-Grandma bought the house fifty years ago for $30,000 and then gifted it to Grandma after she married Grandpa. Grandma’s cost basis is also $30,000. If she sells tomorrow for $400,000…oof! Grandma has a $370,000 capital gain! No wonder she installed that moat.
On the other hand, if the property was transferred by inheritance – that is, the previous owner passed away and ownership transferred to their heirs after death – in this scenario, the heirs get a stepped-up basis for the inherited property.
Stepped-up basis means the cost basis of the property is adjusted to match that property’s Fair Market Value (FMV) on the day the previous owner passed away.
Great-Grandma bought the house fifty years ago for $30,000 and stayed there until she died, at which time Grandma inherited the house. The property was worth $200,000 when Great-Grandma died. Grandma’s cost basis became $200,000 at that time.
If Grandma spends the rest of her life in that home, the basis will get stepped up again when the house passes down to her children.
Strictly from a tax perspective, this is generally viewed as the ideal situation – let property pass via inheritance in order to get a stepped-up basis, and minimize the capital gains tax.
Assuming you’ve been treating Grandma right, I’m sure she wants whatever wealth she leaves behind on this world to end up in your bank account, and not in the U.S. Treasury!
As much as we all love to save tax, there could be other non-tax issues to consider during Grandma’s twilight years. Certain objectives might require you to transfer ownership of Grandma’s house to other family members during her lifetime, even if she continues to live in that home after the transfer.
Perhaps you’re wondering if there’s a way to have your cake and eat it too – transfer ownership during Grandma’s lifetime, and preserve the basis step-up upon her passing.
Of course, Grandma would insist that you eat any piece of cake that is presented to you. So fortunately, there are ways to achieve this “best of both worlds” tax outcome.
The key question is, after the transfer…
3. Who controls the house?
We know the practical answer is, Grandma. Who else could force-feed you two giant slices of cake thirty minutes before you plan to eat dinner?
The Tax Code looks at other factors besides forced cake consumption. When ownership is transferred before death, close attention must be paid, to determine if the transfer was a completed gift, for tax purposes.
If Grandma maintains certain powers over the house after she gifts it away – such as the power to decide who receives the proceeds when the house is sold – the transfer would be considered an incomplete gift.
If the gift was incomplete, then Grandma is still considered the owner for tax purposes, even if a different name is now on the deed. When she passes away, the house will get a stepped-up basis.
The most common example of an incomplete gift would be transferring property to a revocable trust, sometimes referred to as a living trust. With this type of trust, the donor maintains the right to reclaim ownership of any property they put in the trust, at any time.
On the other hand, when someone transfers property to an irrevocable trust, they typically forfeit any rights to reclaim that property in the future. Such a transfer would be a completed gift.
If Grandma owns the house as an individual until the day she dies (that is, her own legal name is still on the deed), her heirs will need to go to probate in order to settle her estate.
Probate is a legal proceeding where the court validates the decedent’s will (if one exists), appoints the individual who’s in charge of administering the estate (the executor or executrix), determines the value of the decedent’s assets, and oversees the distribution of those assets to the estate’s beneficiaries.
Depending on the circumstances (and the state where the decedent lived), probate can be a complex and lengthy process, taking anywhere from a few months to a few years.
If Grandma thought you were working too hard after 45 minutes of light-duty yard work, she certainly wouldn’t want to torture you with a year of court appointments.
Putting Grandma’s property in a trust before she passes is one way to avoid the probate process. The trust document (rather than the court) dictates how the estate gets settled.
If Grandma’s only goal is to avoid probate, the best option may be to form a revocable trust. For tax purposes, Grandma would still be considered the owner of her house after she puts it in the trust, so the house will get a stepped-up basis after she passes.
But there could be other objectives that the family is hoping to achieve, besides merely avoiding probate.
Maybe there are concerns about Grandma’s long-term health and ability to live independently, and you need to plan for the possibility of moving her to a nursing home or assisted living facility, or paying for 24-hour home health aides.
Such services and facilities can be quite expensive, costing $50,000 to $100,000 per year, or more depending on the location and the types of services being provided.
Grandma is one of the only people still sending you a birthday card each year, and she’s definitely the only one dropping a check in the envelope. You know it would break her heart if her precious home was sold and all the money went to the shareholders of Golden Sunsets Incorporated.
In this scenario, an irrevocable trust might be favored, in order to protect Grandma’s home from creditors. Grandma cannot be forced to sell her home to pay for her care, if she no longer owns her home and has no power to reclaim ownership.
This strategy is part of Medicaid planning – restructuring Grandma’s income and assets so that her resources are not depleted by the potential, future costs of her care. The goal of this restructuring is to one day apply to the Federal Medicaid program to get financial assistance with these costs.
Medicaid planning is very complicated and requires the support of an attorney, ideally one who specializes in elder law. That attorney will likely need to consult with other professionals (tax accountants, financial advisers, geriatric care managers) to ensure that all aspects of Grandma’s situation are given due consideration.
To return to the focus of this article, you might be wondering, what are the tax consequences of selling the home after it’s been put in an irrevocable trust? Do you lose the ability to step up the basis when Grandma has passed away?
Usually, yes, but not necessarily. An experienced elder law attorney can probably recommend some creative, if not convoluted, ways of preserving the basis step-up after transferring the house to an irrevocable trust.
One possible solution is to utilize a life estate. A life estate transfers legal ownership of Grandma’s house to another individual, group of individuals, or entity (such as a trust), while guaranteeing Grandma the right to live in her house for as long as she wants, for the rest of her life if she wishes.
Since Grandma has retained a significant level of control over the house, the house can be included in her estate for tax purposes – IF she stays there for the rest of her life, that is. In this scenario, the house will get a stepped-up basis upon her death.
What if Grandma sells the house during her lifetime? Maybe Medicaid won’t pay all of her nursing home costs and selling is the only way to cover the shortfall. Or maybe Grandma is tired of those early bird specials and wants to hit the slot machines!
Whatever the reason may be, if you need to sell and cannot step up the basis, the final question you should consider is:
4. How can we legitimately minimize the capital gains tax on the sale?
If Grandma has lived in the house for at least two of the past five years, and if she’s still considered the owner for tax purposes, she will qualify for what’s called a Section 121 exclusion on the sale.
For a single taxpayer (unmarried or widowed), this exclusion exempts the first $250,000 of capital gain income from taxation. For a couple filing Married Joint, the exclusion is increased to $500,000.
While that can yield a robust tax savings, the 121 exclusion is not always enough to completely wipe out the capital gains tax from a house sale.
Seventy years ago, the median home price in the US was about $18,000, compared to $374,000 today. If Grandma is a widow and has lived in her home for several decades, she may indeed realize more than $250,000 of gain from the sale.
If you find Grandma still has some taxable gain after factoring in the 121 exclusion, your next task is to fight through that barricade of old air conditioners and Life magazines, and dig through her file cabinet for records of any prior capital improvements made to the house.
While Grandma might be thrifty and still has a “70’s brown” theme going on, if she lived in that house long enough, chances are she had to pave the driveway, put on a new roof, and replace the water heater and furnace, at some point.
The cost of major improvements such as these can be added to the cost basis of the house. If Grandma bought the house for $30,000 and then made $100,000 of capital improvements over the next fifty years, her adjusted basis is now $130,000.
While you’re elbow-deep in that file cabinet, hunting for old bank statements and receipts, look out for the closing statement from the original purchase, along with the statements from each mortgage refinance. Closing costs that were never deducted on a prior tax return (title fees, recording fees, inspection and appraisal fees, etc.) can also be added to the cost basis of the house.
And in certain situations, you might find you have an ace up your sleeve, thanks to one Mrs. M. Lee Gallenstein.
In 1992, Mrs. Gallenstein defeated the mighty Federal government in U.S. District Court, over a dispute with the IRS about how to compute the cost basis of her home.
The dispute specifically related to joint interests – properties where both spouses were listed as owners on the deed – and how this joint interest affected the estate of the spouse who was the first-to-die.
The Tax Code was originally written such that the value of jointly-owned property would be included in the estate of the first-to-die spouse, to the extent that spouse contributed money to the purchase of the property.
If Grandpa contributed 75% of the money for the house purchase, and if Grandpa died first, then 75% of the house value would be included in his estate – and thus, the house would qualify for a prorated stepped-up basis. Grandma’s cost basis becomes 75% of the house’s FMV on the date Grandpa passed, plus 25% of the original purchase price.
Congress amended the Tax Code in 1976 to change this treatment. Going forward, joint owners would be treated as equal 50-50 owners regardless of who contributed what to the purchase.
Mrs. Gallenstein successfully argued in court that any jointly-owned house that was purchased prior to 1977 should be subject to the old tax law.
In this case, her house was purchased in 1955, and her late husband contributed 100% of the money for the purchase. The court agreed that 100% of the house value should be included in her husband’s estate, and thus the house qualified for a full step-up in basis.
Mrs. Gallenstein was awarded a $115,000 tax refund for her troubles!
This has become known as the Gallenstein rule and is a very helpful tool for minimizing capital gains tax on the sale of houses that were bought before 1977, especially when the first-to-die spouse was the primary breadwinner in the family.
Hopefully, your sale of Grandma’s house will not land you in Tax Court. While the tax and legal issues involved in these situations can often be quite complex – and the emotions in the family can sometimes run hot – bringing in qualified specialists can help steer the course of events toward a desired outcome, or at least avoid a particularly undesirable outcome.
Now that you know Grandma’s wishes can be honored without necessarily paying a small fortune to the IRS, it’s time to pay her a visit, cut a big slice of cake, and start talking next steps!
