When my spouse dies, do I get a full increase in my home base or just the $250,000 capital gains exemption?

What if a husband and wife jointly own a home that increases in value by $500,000. When one spouse dies and the other owns the property themselves, do they get a step-up basis? Or do they only get a $250,000 capital gain exemption when they sell the property?

– Samuel

Your question relates to the rules regarding both the step-up on an inherited asset and the capital gain exclusion on the sale of a principal residence. These rules are independent of each other, so both are true: The surviving spouse receives a step-up basis and they only get a $250,000 exemption. It might sound a little confusing, so let’s unpack it below.

If you have similar tax planning questions or need help managing your investments, we recommend speaking with a financial advisor to see how they can help.

About Step-Up in Basis

In finance, the term “basis” generally refers to the amount you pay for something. Basis matters because it is the starting point from which you calculate taxable earnings. For example, let’s say you buy something for $100,000—that’s your basis. If the asset’s value increases to $150,000 and you decide to sell it, you’ll owe $50,000 in capital gains taxes.

A basis step-up occurs when the basis of an inherited asset is reset to its market value at the time of the original owner’s (or co-owner’s) death. In other words, when a person inherits assets such as stocks or real estate, the tax basis is adjusted to reflect the value of the asset at the time of ownership, rather than the amount originally paid for it.

Going back to the example above, let’s say you have an asset with a basis of $100,000 and at the time of your death its value has increased to $150,000. Instead of inheriting your original base, your heir receives a “stepped up” base. In this case, their new basis is $150,000 and they will not realize a gain unless the property continues to appreciate.

(Basis-stepping accounting is an important component of tax planning and estate planning. A financial advisor with experience in either area can help you use this tax loophole.)

Capital gains and the sale of a primary residence

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The tax code allows you to reduce or avoid capital gains tax on the sale of a principal residence, provided you have lived in it for two of the last five years. This tax break is known as the Section 121 exclusion.

There are parameters you must stay within to qualify for this tax break, but the general guidelines are as follows:

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• Individuals can exclude up to $250,000 of gain from the sale of a principal residence

• Married couples filing jointly can exclude up to $500,000 from the sale of a principal residence

So, let’s say the basis for your primary home is $300,000. If you’re single, you can sell it for up to $550,000 without having to pay capital gains tax. A married couple could sell it for as much as $750.00. This example ignores transaction costs to provide a simplified illustration. You’ll want to work closely with your tax professional to make sure you calculate your basis correctly. (And if you need help finding a financial professional, this free tool can connect you with three fiduciary advisors serving your area.)

Combining the two rules

Samuel, to see how both of these rules apply to the situation you’re asking about, we need to think about them in order:

• First, determine the accelerated basis

• Second, calculate the taxable gain taking into account the Section 121 exclusion

Step 1: Set the base

The surviving spouse gets a step-up basis when the first spouse dies. However, the amount of this adjustment depends on whether you live in a community property state. In a community property state, the surviving spouse receives a full step-up basis. It means their basis becomes the fair market value of the asset at the time their spouse passed.

In a non-community (common law) property state, the surviving spouse only receives a step-up based on one-half of the property’s appreciation. For example, the couple’s joint basis is $300,000, but the home is worth $500,000 when the first spouse dies. Half of that $200,000 gain is added to the surviving spouse’s basis, so they have a basis of $400,000 on a home worth $500,000.

Step 2: Calculate the capital gain and apply the exclusion

After the surviving spouse has determined the step-up basis of the inherited home, the surviving spouse can then calculate what the taxable gain would be if he were to sell the property. And remember, they would only owe capital gains tax on the portion of that gain that exceeds the Section 121 exclusion.

Here’s a final example to tie it all together:

A couple living in a community property state owns a home worth $500,000 after initially paying $300,000 for it. The first spouse dies and the surviving spouse’s tax basis is increased to $500,000. The surviving spouse can then sell the home for up to $750,000 without recognizing a taxable gain because of the $250,000 exclusion.

One final nuance here: the amount of the exclusion depends on your tax filing status. “Married filing jointly” status gets a $500,000 exclusion, while “married” status gets a $250,000 exclusion. Widows and widowers are allowed to maintain their married-in-joint status in the year of death. So the surviving spouse could still exclude the full $500,000 if they sell the property in the same calendar year that their spouse dies. (But if you need additional help with your tax strategy, consider working with a financial advisor with tax experience.)

Conclusion

When one spouse dies and the surviving spouse is deciding what to do with the jointly owned home, it’s important to understand the rules for stepped-up basis and the capital gains tax exclusion. The surviving spouse will receive a major basis that could adjust the inherited home to its fair market value at the time of their spouse’s death. If they were to sell it, they could still apply the Section 121 exclusion and avoid paying capital gains taxes on up to $250,000—and in some cases, $500,000—on the sale of the home.

Tax planning tips

• If possible, consider delaying the sale of appreciated investments until you’re in a lower income tax bracket, such as after retirement. Long-term capital gains are taxed more favorably, and if your income is low enough, you may qualify for a 0% capital gains tax rate. To see how much you might owe when you sell your assets, try our capital gains tax calculator.

• A financial advisor with expertise in tax planning and/or financial planning can help you determine the best time to sell assets to minimize the tax implications of the sale. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool matches you with up to three verified financial advisors serving your area, and you can have a free introductory call with your matched advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help reach your financial goals, get started now.

Brandon Renfro, CFP®, is SmartAsset’s financial planning columnist and answers readers’ questions about personal finance and tax topics. Have a question you’d like answered? Email [email protected] and your question may be answered in a future column.

Please note that Brandon is not an employee of SmartAsset and is not a SmartAsset AMP participant. He has been compensated for this article. Some questions submitted by readers are edited for clarity or brevity.

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