How are Capital Gains in Life Estate Affected by Improvements?
My mother has quitclaimed the deed of her house to me while retaining a life-use interest. There may be a future potential to sell the house prior to her death if she wants or needs to move in with me. I believe she will qualify for the capital gains tax exemption as calculated by her life estate interest, but I would be subject to capital gains on 100% of my interest. If I pay for capital improvements while she is living there, can I deduct those from my interest of the gains tax? It seems that would be more beneficial, as she already has the exemption to apply.
You are right that if you were to sell the house during your mother’s life, the proceeds would be split between you based on your shared interest. The split is determined by an IRS table that factors in your mother’s age and the current interest rates. Your mother’s interest gets smaller as she gets older.
For instance, if your mother’s house sells for $400,000, she might be entitled to $100,000 and you might be entitled to $300,000 of the proceeds. The capital gains are determined as the difference between the net sales price (after a broker’s commission) and the property’s tax basis. If the basis in the house is $120,000, then the taxable gain would be $280,000. These gains would be attributed to you and your mother in proportion to your ownership interests. Using the one quarter – three quarters proportions example above, $70,000 of the gain would be attributed to your mother and $210,000 to you. You are correct in saying that your mother can waive up to $250,000 of this gain, since it’s her house, but you cannot, since you don’t live there.
You are also correct in saying that you can increase the basis by investing in the house. However, this may or may not make sense for tax and investment purposes. This is because while you would be investing the money, the increase in the tax basis of the property would still be attributed proportionally to your and your mother’s shares. For example, if you were to put $80,000 into the house, this would increase the basis to $200,000. If you still sold it for $400,000, the gain would be reduced to $200,000 and your taxable share to $150,000, but at a cost of $80,000. So that doesn’t sound like a good deal. Of course, if the enhancements were to increase the value of the house by more than the investment, perhaps to $500,000, your share of the proceeds would increase to $325,000 and your taxable gain to $225,000. This may or may not be worth the effort.
Finally, be aware that upon your mother’s death, the property’s basis gets adjusted, or “stepped-up,” to its value at that time—essentially eliminating any capital gain and any tax due. To learn more about how this works, read my post, What’s a “Step-Up” in Basis and Why Would You Want it?