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Question:

My mother’s house is in a life estate with the remainder in my sister’s and my names. She (our mother) is 86. When she passes how do we determine how much in capital gains we will owe. We have been told that it will be the difference between the fair market value of the house and the actual selling price.

Response:

That’s basically correct. When the owner of property passes away, its tax basis gets adjusted to its fair market value on the date of death. This  is often referred to as a “step up” in basis or “stepped-up” basis. Typically, if the property is sold relatively soon after the owner’s death, the sale price is used as the fair market value since the best way to determine market value is to put the property up for sale and see what buyers are willing to pay.

Property owned in the form of a life estate receives the same tax treatment as long as the life estate holder — your mother in this case — is the person who created the life estate. In other words, if your mother owned the property and then signed the deed creating the life estate, it will receive a step-up upon her death. On the other hand, if someone else created the life estate, it will not receive a step-up. For example, if your grandparents left the house to your mother for life with the remainder passing to you and your sisters, it would not receive a step-up in basis upon your mother’s death.

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