Question: My sister passed away in January of 2000. She owned and resided in a cooperative apartment in New York City for many years, until her death. As executor of her estate, I sold her shares in the apartment in February of 2001. Does this event fall under the sale of personal residence rule and qualify for the exclusion of $250,000 of capital gain to my sister?

If this cannot be considered as a sale of my sister’s principal residence, is the inherited property a business investment transaction for me? As sole heir, I inherited her estate but the cooperative apartment shares were never transferred to my name. I had the apartment appraised as of the date of death and continued to pay all expenses for the maintenance and preparation of the apartment for sale.

Answer: Your first question is easy. No, the estate is not able to take advantage of the principal residence exclusion of up to $250,000 in capital gains tax (or $500,000 if the property owners are married and file a joint tax return).

The estate did not (and could not) live in the apartment for two out of the last five years before the apartment was sold. Unfortunately, on the death of your sister, the tax laws will not permit that principal residence exclusion.

However – and depending on local State law – on your sister’s death, you, as Executor (also called Personal Representative) became the owner of the apartment. Here, the concept of the “stepped up” basis comes into play.

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.

By way of illustration, if your sister purchased her apartment 17 years ago for $50,000.00, and over the years have made $25,000 in improvements, her basis for tax purposes would have been $75,000. If she had sold the property before her death for $325,000 or less, she would not have had to pay any tax on her gain. As described above, a taxpayer who lives in her house for two years before it is sold can exclude up to $250,000 in gain from tax. ($325,000-75,000 = $250,000).

However, your sister did not sell the property. Thus, on her death, you -- as her sole heir -- will receive the benefit of the "stepped-up" basis rule. When you sold the apartment, you will only have to pay tax on the difference between the market value on the day of death and the actual sales price. If the value of her property on the date of her death has increased to $500,000.00, and you sell the apartment for that price, no Federal income tax will be owed. Keep in mind that we are only discussing income tax and not inheritance tax, or any applicable New York State taxes applicable to estates.

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.

The law further goes on to address community property states (which are predominantly in the Western part of the United States), where each spouse has an undivided half interest in community property. In those states, an heir, devisee or legatee obtains the decedent's half interest from the deceased spouse, and is entitled to a stepped-up basis under the general rules.

The surviving spouse is also entitled to a stepped-up basis for his or her half interest if at least half of the community property in question is included in the decedent's gross estate for tax purposes.

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.

Your sister could have given the property to you before her death, but in my opinion, this would have been a gross mistake. Let’s look at this example: we have decided that her tax basis was $75,000. Had she given you a gift, your basis for tax purposes would be the same as the grantor -- i.e. $75,000. If you subsequently sold it for $500,000, since you did not live in the property for at least two years, you would have to pay capital gains tax on $425,000. At the current tax rate of 20%, this means that Uncle Sam would have been given a gift of $85,000. Instead, when you inherited the property, you received the benefit of the stepped up basis. If you sold the property at that same valuation, you did not have to pay any capital gains tax at all.

Obviously, the decision on whether to sell one’s property while living or pass it on to your heirs is a very important -- and personal -- decision. Some people want to make sure that their heirs will be properly protected on their death. Other people might very well want to make sure that they are protected while they are living.

But the tax consequences are – or should be – an important part of this decision.

Published: February 25, 2002

Use of this article without permission is a violation of federal copyright laws.