Question: My mother died three years ago and my father died one year later. My father's will left everything to my two sisters and me. One of my sisters was living in my parents' house for the past four years and currently lives there. I am the executor of the estate but have not yet transferred the title. We are all in agreement that the house should be hers.

My question concerns the capital gains treatment. If my sister sells the house less than two years after the title is transferred to her, will she be obligated to pay capital gains tax on the difference between her sales price and the value of the house either on the day my father died or when the property was transferred to her? Alternatively, will the fact that she has lived in the house prior to and since the day my father died allow her to claim the $250,000 exemption?

Answer: You raise a host of issues with your question.

First, did your mother and father own the property as tenants by the entirety or as joint tenants? If so, then on your mother's death, the property automatically vested in your father, and then on your father's death, his will controls the disposition of the house. However, if for any reason your parents owned title as tenants in common, then on your mother's death, her interest in the property would have to be probated. Please have your probate attorney confirm the status of title.

In most states in this country, the Executor (also called Personal Representative) will automatically obtain title to the property on the death of the owner, and will either have the authority to sell the property or convey it to the beneficiaries names in the Last Will and Testament. If there is no will, each state has laws (called "intestacy laws") which control how property is to be distributed.

Regardless of where title currently is, your father's will directed that the house should go to you and your two sisters.

Let's go to your specific question. Let us assume that your parents purchased the property 25 years ago for $50,000. Let us also assume that they made no improvements to the property. When your mother died, the property was appraised at $300,000, and on your father's death it was appraised at $400,000.

In any discussion of capital gains tax, we have to determine what is known as the "basis" of the property. Basis is generally defined as the initial purchase price, plus any improvements, less any depreciation which has been taken. In our example, there were no improvements, and since this was not rental/investment property, there was no depreciation.

However, there is a concept known as the "stepped up" basis, which oversimplified means that the basis is the fair market value on the date that your father died. There is an alternative valuation method which is too complicated to explain in this column, but could allow basis to be determined at a date which is six months after death.

Thus, when your father died, the basis of the property was $400,000, or $133,333 for each of the three sisters. Do you plan to give one of your sisters the entire house as a gift, or do you plan to sell her your respective interests? If you want to gift your share to her, then you will have gift tax consequences. Although you will not have to pay any gift tax, you will have to file a Gift Tax Return with the IRS, and this may have significant consequences for you -- and your estate -- down the road.

If, on the other hand, you sell your interests to her based on a total price of $400,000, you will have no capital gains tax to worry about. As we have discussed, your collective basis in the property on the date your father died was $400,000 and you are selling the property for this same price, you will make no profit and thus will not have to pay any tax. However, under this scenario, your sister will have to pay the estate $266,666 – which is the difference between the market value of $400,000 and her one-third interest in the property.

Before you make any decision, you must consult with your own tax advisors to make sure that you are protected financially.

As for your sister who plans to live in the house, we have to determine her basis. On the date of your father, as we have discussed, her basis was $133,333. If you and your sister gift your interests to her, her basis will become $400,000. The basis of the donor (the person giving the gift) becomes the basis of the donee (the gift recipient).

Your final question goes to whether she will be eligible for the $250,000 exemption if she sells within two years of taking title, because she has already been living in the property for some time. The answer is no. In order to be eligible for the up-to-$250,000 exclusion of gain ($500,000 if you are married and file a joint tax return) you have to have owned and lived in the property for a period of two out of the previous five years before the property is sold. You sister will not be considered the "owner" until title to the property is in her name.

The IRS recently issued rules regarding sales which occur before the two years have expired. If your sister has to sell, for example, for health reasons, or because she has a job transfer out of the area, she may be eligible for a pro-rated exemption.

This is a complicated situation. You obviously want to do right for your sister, but you obviously do not want to create future problems for yourselves. The bottom line: you and your sisters must get specific tax and legal advice now, before the property is transferred.

Published: November 29, 2004

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

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.