If your wife were still alive, since you have lived in the house for more than two years prior to its sale – and you have filed a joint tax return – you are eligible to exclude up to $500,000 of gain. Thus, in your situation, you would have had to pay no tax on the profit you have made.

However, your wife died two years ago. Now we have to explore another tax issue, called the “stepped up” basis.

Oversimplified, the basis of inherited property for income tax purposes is the fair market value of the property at the time of the decedent's death. This is commonly referred to as the "stepped-up" basis rule.

According to the Tax Code, the stepped-up basis applies to property "acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent. . ." This means that whether the decedent has a will, or dies intestate (without a will), the beneficiary is eligible for that stepped-up basis.

There is, however, an alternative valuation rule which can be adopted. This alternative valuation gives the taxpayer the election to value the property six months after the date of death or at the date of disposition, if earlier. The purpose of this election is to afford some limited tax relief to estates which have experienced a decline in the value of assets during that six month period.

Let’s assume that two years ago, when your wife died, the property was worth $500,000. You and your wife owned the property as tenants by the entirety – i.e. jointly. When you first purchased the house for $40,000, your individual basis was $20,000.Because you added improvements in the total amount of $100,000, your individual basis was increased by $50,000 to $70,000. On your wife’s death, since the property was then worth $500,000, you inherited half of her basis at the stepped up rule – in the amount of $250,000.

Accordingly, your revised (stepped up) basis is now $320,000 (your basis of $70,000 plus the stepped up basis of $250,000).

Now we get back to computing the capital gains tax. The amount realized was $568,000. If we subtract your basis of $320,000, that leaves you with a capital gain of $248,000. The law allows you – as a single taxpayer – to exclude up to $250,000 of gain. Thus, the happy news: you will not have to pay any capital gains tax at all.

One note of caution. In the years before l997 (when the new tax law was enacted) there was a concept called the “rollover”. Oversimplified, if you sold your principal residence and within two years from the date of sale you purchased another property which was equal to or greater than the selling price of the old home, you did not have to pay capital gains tax on any profit you made. Instead, this profit was rolled over into the new house. Thus, if you had made a profit of $10,000 when you bought your current house for $40,000, your basis would have been $30,000 ($40,000 - 10,000) instead. If you took advantage of that rollover when you bought your current house, you should consult your tax advisors to make absolutely sure what your real basis will be.

You have raised a question about taxes, but I also want to raise another issue – namely do you want to sell your property, and if so, under what arrangements.

Have you talked with your children? Do they (or any one of them) want the house? Is it in good condition? Is it is a neighborhood where appreciation will continue?

Under no circumstances should you give the house to your children. We have determined that your basis is now $320,000. If you gift the house to anyone, your basis becomes their basis. Thus, if they sell the house at a later date, unless they actually have lived in the property for two out of five years before the sale, they will have to pay a lot of capital gains tax.

But why not consider selling the house to them. Since you own the property free and clear, you can take back all of the financing, and they can pay you a monthly mortgage. If you want – and if you can afford it – you can gift them back, each and every year, up to $11,000 per person.

There are many options available to you. But your financial well-being must be your primary concern, and if you need assistance, discuss your situation with a financial counselor prior to making any decisions – or taking any action.

Death may be inevitable; but taxes can be planned and indeed legally and creatively avoided or reduced.