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Question:

My parents created a life estate in Rhode Island. My dad passed away in 2022. The estate attorney noted the value of the home at $852K. Based on the life estate his estate reflected his amount of the estate based on his age interest. My mom is the surviving life tenant. October 2024 the house was sold for $830K after mom was placed in skilled nursing. I am trying to determine how to estimate the capital gains owed.

Response:

The missing pieces of information to determine the capital gain is what your parents paid for the property, the cost of any improvements they may have made to it, and your mother’s age.

Capital gains are based on the difference between the sales proceeds at the property’s tax basis. The basis starts out as the purchase price, but the cost of improvements can be added in. Normal maintenance, such as painting, does not count. But the cost of improvements such as replacing the kitchen or adding a garage can be added to the property’s basis.

In addition, when an owner dies, the basis is adjusted to the fair market value on the date of death. This is often referred to as a “step up” in basis or “stepped-up” basis. Since your father was the half owner of the property, it received a one-half step up upon his death.

So let’s do the numbers. I’ll assume for this purpose that your parents bought the house for $250,000 and made $50,000 worth of improvements over the years, bringing the basis up to $300,000. To calculate the basis after your father’s death, we add half of the original basis to half the date of death fair market value. In our example, the total is $576,000 (($300,000 + $852,000)/2 = $576,000). Using these numbers, the capital gain was $254,000.

But the next question is how this should be allocated. I assume that you and your siblings are the so-called remaindermen of the property. This means that you are also owners along with your mother and, as such, you are entitled to a portion of the proceeds. The value of your various interests, your mom’s and yours, is based on your mother’s age and prevailing interest rates. The IRS provides tables here for valuing life estates.

Assuming for purposes of example that your mother is 84 years old and the current 7520 rate, the one customarily used for these purposes, is 5.0%, your mother’s interest would be valued at 27% and that of the remaindermen at 73%. Both the allocation of the proceeds and that of the capital gain should follow these percentages. Of the $830,000 in proceeds, $224,000 should go to your mother and $606,000 to the remaindermen. Using our example of the capital gain, $68,580 should be allocated to your mother and the other $185,420 to the remaindermen.

Your mother won’t pay any tax on her share of the gain since she can exclude the first $250,000 of gain on the sale of her personal residence. The remaindermen, on the other hand, will have to pay taxes on their share of the gain.

(Given the timing, if your mother’s gain were to exceed $250,000 she might be able to use your father’s $250,000 exclusion as well. Surviving spouses are entitled to use their deceased spouse’s capital gain exclusion if they sell their home within the two years following their death. Depending on when in 2022 your father died, your mother may be able to use his exclusion as well as her own.)

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