Will House Deeded to Spouse Just Prior to Death Receive Step-up in Basis?
If two spouses deed their primary home, within one year of one spouse’s passing, from their living trust to the ill spouse, and the ill spouse had willed everything to a (completely discretionary) trust for the other spouse’s benefit, is any/half/all of the house eligible for (1) a step-up in basis and (2) the $250,000 capital gains exclusion on the property’s sale? Assuming the surviving spouse’s only income is a tiny social security check and the house is worth less than $250,000, does it matter if the house is sold?
There are a few different issues here. First, how much if any of the house will receive a step-up in basis upon the first spouse’s death? Normally, if the house was in the decedent’s estate, it would all receive a step-up in basis upon his or her death. In your case, that would be $250,000. If the house were sold for $250,000, there would be no capital gain on the property’s sale and no tax. However, there’s an exception for property received from ultimate recipient within the year prior to the decedent’s death, in which case it does not receive a step-up in basis. So, under your fact pattern, since the deceased spouse received the property within a year before death from a joint trust, half of it would be deemed a gift from the surviving spouse and not eligible for a step-up. So the property would have a one-half step-up in basis to $125,000 plus one-half of the prior basis. So, for instance, if the house was purchased for $50,000 (and there were no basis adjustments for improvements or depreciation), the new basis would be $150,000 ($125,000 + ($50,000/2) = $150,000), and the capital gain on its sale for $250,000 would be $100,000.
Interestingly, if the the house had remained in trust, it might have received a 100% step-up in basis. Often joint marital trusts include a general testamentary power of appointment giving the first spouse who dies the right to direct through his or her will where the trust property will go. If the trust grants this power,then the entire trust will be includible in the taxable estate (though no estate tax will be due given the low value of the estate) and receive a full step-up in basis to the fair market value of the house when the spouse died.
Now that we’ve established that there will be taxable capital gain on the property’s sale, the next question is whether the surviving spouse can exclude the first $250,000 of this gain under Section 121 of the Internal Revenue Code because it is her home. In order to qualify for the exclusion, you must have owned and lived in the property for at least 24 months during the prior five years. While the surviving spouse no longer has an ownership interest in the property, since it’s in a trust for his or her benefit created by the deceased spouse, the surviving spouse did own it through the revocable trust for at least two out of the prior five years. So, it would appear that the surviving spouse does qualify for the exclusion for at least three years following the transfer to the ill spouse. In addition, there’s an extension to this rule for widows and widowers. They may count the deceased spouse’s time of ownership, which would extend the time for taking the exclusion to three years after the deceased spouse’s death, rather than three years after the transfer.
So, if the surviving spouse sells the house within three years of the deceased spouse’s death, he or she can exclude the first $250,000 gain (in your case, all the gain) on its sale. However, since the house was fully in the deceased spouse’s name for less than a year, it received only a one-half step-up in basis upon his or her death.