Navigating the Personal Residence Capital Gains Tax Trap for Seniors

As a senior citizen ages in her residence, she begins to understand a problem that has been brewing for years or decades. The house that she bought many moons ago with her husband has slowly appreciated in value over the years. Maybe she bought it in the 1980’s for tens of thousands of dollars and now it is worth hundreds of thousands of dollars…maybe more than a million. How does she navigate (and mitigate) the tax implications of a potential sale of the house? Is she better keeping the home and leaving it in her Will to her children? How does the new Washington Capital Gains tax apply?

Let’s add some names and numbers to showcase an example. Margaret and her husband Philip bought a home for $64,000 in 1983 and have lived in the same home since that time. The house is worth $1,064,000 today (an increase in value of $1M). Philip passed away in 2018 when the house was valued at $800,000. The house is too big for Margaret and the maintenance is burdensome, so she is contemplating selling.

Capital Gains Tax

In general, the sale of any asset (including a house) is subject to a capital gains tax on the increase in value from the so-called “tax basis.” The tax basis starts with the purchase price (here, $64,000) but can be adjusted. Ostensibly, the increase in value is $1M, which would be the “gain” subject to the capital gains tax.

But in working through possible tax basis adjustments, Margaret would want to dig a little deeper and catalogue her extensive list of remodels and repairs she has put into the house over the years to keep it shipshape. These expenditures would generally be added to the purchase price and increase the tax basis. So, imagine she can show $100,000 of remodels and repairs she has made. The gain is reduced by the same amount down to $900,000.

Exclusion for Personal Residence

The law also provides a specific exclusion for gains associated with a personal residence in the amount of $250,000 (for individuals) or $500,000 (for couples) so long as the home was used as Margaret’s main home for at least two of the last five years.  So, Margaret might apply the exclusion and take that $900,000 gain and reduce it by $250,000. Still, that would leave gains of $650,000.

Step up in Tax Basis

It is important to note an intriguing tax issue at death that upends all the previous analysis: the step-up in tax basis. The tax code provides a boon for individuals with capital assets (think stocks, land, buildings, real estate, and of course personal residences). That is, at death, the asset gets a new basis equal to its then current fair market value. Taking the example above of the house – if it is sold after Margaret’s death, it gets a new tax basis equal to the then current fair market value of $1,064,000. Accordingly, when it is sold for $1,064,000 after her death, the taxable gain is zero. This means there will be zero income tax assessed on the sale of the capital asset after death. Does that mean that Margaret should keep the asset through her death and leave it in her Will to her children? Her children would certainly enjoy the lower income tax burden, but Margaret would experience no savings herself.

But there is another twist to the step-up analysis. That is, in community property states like Washington, all assets owned by the community get a step-up in tax basis upon the death of a spouse. That means that the tax basis should have been adjusted to the fair market value of the house as of Philip’s date of death back in 2018. Accordingly, the calculation of potential capital gains for Margaret during her life would be the current fair market value ($1,064,000) less the basis (which should have been adjusted in 2018 to the then fair market value of $800,000) for a total gain of $264,000. But Margaret can still apply any costs of remodeling or repairs since 2018 that can further raise the basis. Her goal is to track enough expenses to raise that basis just $14,000 more to $814,000. That would make the total gain clock in at $250,000 – an amount of gain that can be fully excluded and therefore allow Margaret to pay no capital gains tax.

New Washington Capital Gains Tax

Washington recently implemented its own version of a capital gains tax. Good news. The new capital gains tax passed here in Washington specifically exempts real property (like house and land) from the application of the tax. In this example, the Washington capital gains tax would not apply because the gains are attributed to the sale of real property.

Other Situations

Margaret’s example is of course cherry-picked. There are many people who have not been married and are not entitled to any step-up in tax basis upon a spouse’s passing, and still others that have experienced gains well above any exclusion amount. Every situation is different, but the framework of analyzing the tax can help to start the conversation for mitigating tax. Work with your tax professional to analyze your particular circumstances.


The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.