Corona, CA asked in Tax Law and Real Estate Law for California

Q: Will I receive a $250,000 tax exclusion under Prop 13 from selling inherited ownership (less than 100%) in property?

My parents bought the home in 1995 and owned it 50/50. About 6 years ago they divorced and my mother moved out and my father stayed living in the home with my brother and me. My father recently passed in June of 2021 and left his 50% ownership to my brother and me in his trust. My mother is gifting her ownership to my brother and me and my brother wants to buy me out and become sole owner of the house. I was told that my father was entitled to the tax exclusion from living in the house 2/5 of the past years and that I would inherit that (I also lived in that house my entire life). Can you please confirm if I will be able to get the tax exclusion and if there are any time limitations or other restrictions?

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1 Lawyer Answer
D. Steven Yahnian
D. Steven Yahnian
  • Tax Law Lawyer
  • Visalia, CA
  • Licensed in California

A: You shared a lot of facts and posed what ultimately appears to be a income tax question concerning the tax effect of your sale of your 1/2 interest in the house. You are not asking about the effect of Proposition 19 on the property taxes you would pay.

Here are the income tax rules that may apply to your situation:

1)Your dads one half interest will get step up in basis to fair market value at his date of death. So, the 1/2 that he left in trust for you and your brother will have an income tax basis equal to 1/2 of the house's appraised value at your dad's death. If you sell your interest in the trust for 1/4 of the appraised date of death value, it would appear that you will be able to exclude the gain from that fractional interest sale because of the date of death step up in income tax basis, not the 2 out of 5 year rules of IRC 121. The 2 out of 5 rule would not be relevant unless the sale price is more than your share of date of death value.

When a decedent’s principal residence is transferred to a surviving spouse, the decedent’s periods of ownership and use carry over to the surviving spouse, provided the surviving spouse has not remarried when the residence is sold or exchanged [IRC Sec. 121(d)(2); Reg. 1.121-4(a)]. For other taxpayers inheriting a decedent’s residence, including the decedent’s estate, gain must be recognized to the extent the sales proceeds exceed the property’s FMV at the date of the decedent’s death (or alternate valuation date, if applicable). If, under IRC Sec. 1014(a), the basis in property acquired from a decedent is the property’s FMV at the date of death (or alternate valuation date, if applicable), the holding period of the decedent’s residence is automatically deemed to be greater than one year so any gain receives long-term capital gain treatment [IRC Sec. 1223(10)]. However, if the heir uses the property as his own principal residence, the Section 121 gain exclusion rules apply based on the heir’s personal use and ownership of the property.

2)Your mom's 1/2 interest did not get a step up in tax basis at dad's death because it was not community property because they were not married at his death.

When you mom gives you and your brother her 1/2 interest, you will each get an income tax basis equal approximately to what your parents paid for the house when they bought increased by any improvements and decreased by any depreciation they took or were entitled to on their tax returns, if any. So, when you sell your directly owned one quarter interest you get from your mother, you will have gain on the sale, because you did not own and use the residence as your principal residence for 2 of the prior 5 years. If you can wait to sell after you meet these two year tests, (title and use) you may be able to avoid gain on the sale. It sounds like you have lived there for 2 of the past 5 years, but you did not own the property for 2 out of the past 5 years. So, if you can wait for at least 2 years once you get title, at with respect to the one half you got from your mother, you could potentially exclude up to 250,000 dollars of gain. Notice, it is gain you get to exclude.

An unmarried co-owner of a principal residence is entitled to claim the full $250,000 gain exclusion, provided all of the statutory requirements are met, namely the ownership, use, and one sale in two years requirements [Hsu; Reg. 1.121-2(a)(4), Ex. 1].

There are some other ways around this, but you would need to do some in depth additional tax research or see a tax advisor.

Watch out for depreciation recapture also.

Warning: You are strongly advised to seek the services of a tax professional. to answer your questions. My answer is not legal advice and may not be relied upon but is only a brief discussion of the rules. In addition, other facts you did not share with me may impact my response.

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