What to do with a terrible tax bill when you sell your home after your spouse dies

In this blog, we are going to discuss how much in taxes you would pay when selling your home. We’ll cover how to manage the tax bill as well as the deductions you should be considering. Enjoy!

Before we get started, we are financial advisors for widows. We’ve written other blogs on this topic which you can read below.

Financial planning for widows

Widows and annuities

The complete guide to losing a spouse who owns a business

Social Security Survivor Benefits for widows

We also have a podcast for widows that you may enjoy.

And now onto the blog!

What taxes do I pay when I sell my home?

Let’s start at square one. What taxes are you due to pay after you sell a home?

I once knew a couple that bought a home, a beautiful home on a few acres in the country. They renovated the kitchen and the whole thing looked amazing. They put in new hardwood floors. They had a huge pond in the backyard which they filled in, and put in a nice, new fence. The bottom line is that they put a lot of money into the home.

When they wanted to sell it a few years later, the selling price was $1.5 million. It was about three and a half times what they bought it for. This was partially due to the fact that they had revamped so many features. The housing market in their area had also risen considerably.

When you sell a home, you take the sale price and subtract the cost basis, or what you bought the home for. When you improve your home, you add the cost of the renovation to the cost basis.

Capital gain = sale price – cost basis

But if you made improvements,

Capital gain = sale price – (cost basis + cost of home improvements)

Let’s say you bought a house for $500k and sold it for $1.5 million a few years later, as above. The gain would be $1 million.

However, let’s say that you made home improvement, driving up the cost basis to $750k. Now that gain goes to $750k when you sell the home for $1.5 million. The lesson learned here is that when you sell your home, the amount of the gain is reduced by the cost of any of the renovations you make.

Track your home improvement costs

Any renovations should have a life of more than one year to be counted as an improvement. It must be an improvement – not a repair. Talk to any CPA and they’ll say that it can get very tedious to have to go back and track the expenses. It may be easier to organize and track these expenses as you are making home improvements, rather than waiting until the project is complete.

Tax exclusions when selling a home

Why is gain important? Because you have to pay taxes on it at the long-term capital gains rate. Depending on your tax bracket, this is usually 15-20%.

There is some more nuance to it than this – so please don’t interpret this as any kind of tax or financial advice specific to you. If you desire recommendations that can be applied to your personal situation, talk to your CPA or tax advisor.

• • If you are single, you are excluded from having to pay tax on $250,000 of gain, but only if you have lived in the home for two of the last five years.  

• • If you are married and filing taxes jointly, the same rule applies and the exclusion amount of $500,000.

In the previous example, let’s say you had $750k of cost basis. They sold their home for $1.5 million, reaping a $750k gain. However, if they are married filing jointly and meeting all other eligibility criteria, they are able to exclude $500k from this $750k gain, and hence will only have a $250k gain to pay taxes on.

You don’t have to use that money to buy your next home in order to recognize this exclusion. It used to be that way in the past, but the law has changed.

Widows get a $500k exclusion

As we help many widows with their financial planning, we wanted to take a moment to comment on how all of this works if you are selling a home after the death of a spouse.

Many widows downsize their homes after the death of a spouse in favor of a smaller abode or to move closer to family. If your spouse dies, you get to claim $500k exclusion on the capital gain from a house sale, if you lived in the house for two of the last five years.

Some caveats:

You have two years from the date of the death of your spouse to still qualify for that gain, and you must not have remarried over that time period. If you remarried, you only get to use the $250k exclusion.

Widows might get a step-up in basis

Depending on what state you live in, widows get a step-up in cost basis when their spouse dies. This means the cost basis of the house is “stepped up” to market value at the date of death.

• • If you live in a community property state, you get a full step up to the market value.

• • If you live in a separate property state, you get a half step up. 

What’s a half step up?

Let’s say the value of the house is $700k. Theoretically, $350k of that would belong to the deceased spouse and would step up to market value. However, your share of the home, the other $350k, remains the value of previous cost basis. Like we said, there are a lot of nuances here so be sure to consult with your CPA.

Selling a rental property

There was a couple that owned some rental properties and wanted to sell them. They were getting cash flow but needed more income to retire. If they wanted to sell the properties they were going to face large capital gains.

They were selling these rental properties in Utah, so they owed about 20% on the capital gain of $750k, plus 5% Utah state tax. Basically, a quarter of their gain was going to be taken by taxes.

We’ve run into this with several clients – a highly appreciated property will leave you with a huge tax bill when you sell. However, if they were to wait until they were to pass, their children would inherit the property. They’d get the step up in basis and the gain would be gone. The children would inherit the property at the date of death value resulting in no taxes if they sold the property for the date of death value.

This is a long way of saying that rental property is probably better if it is left to your kids. If you have a big tax bill one year because you sold a rental property, there are many charitable strategies or other tax saving strategies you could use. It’s complicated so make sure you get help from an advisor.

Lessening the stress of selling a house after you lose a spouse

Through careful retirement income planning and strategy, loss of a spouse can be managed to the fullest possible extent. There are financial advisors who specialize in working with women in transition after the loss of a spouse. At Rock House Financial, a fee-only financial advisor in Davis County, Utah, we have financial advisors for widows as members of our team. If you would like to speak with us, please reach out.

Thanks for reading, and before you go please check out our podcast for widows.