are capital gains taxes figured differently for heirs than the owner?

Question

my elderly mother-in-law owns several rental properties. she complains constantly about managing them but absolutely refuses to hire a property manager. us kids help where we can but we all have our own jobs and families and busy lives. we're constantly encouraging her to sell the properties and relax (she has a steady income stream from other sources and money is NOT a problem for her) but she doesn't want to sell them because of "the tax consequences". she plans to leave the properties to us kids when she passes but i know not one of us wants them and would just end up selling them eventually anyway. my question: does it make any difference tax-wise whether the properties are sold now while she's alive or by us after she dies?

fwiw, her estate will more than likely be over the $2 million mark.

assuming her accountant has been depreciating the properties over the years (she's owned them for well over 10 years) and that us kids will inherit her entire estate, which option will result in the least net taxes paid to the government ("net" meaning out of the estate and from all the heirs)? all the answers so far (all great, by the way) seem to assume that remainder of the estate will be going to someone other than us.

what would be the tax consequences if she were to transfer title of the properties to us prior to her death?

as for my mother-in-law, she's pretty much stuck in her ways. even though money is not a problem for her, she pinches every penny and doesn't trust anyone outside the family. we tell her she would enjoy life more if she didn't have the rentals hanging over her head but, in a weird and perverse way, she seems to love the feeling of power and importance they give her. so, she complains constantly but, then again, she pretty much complains about everything.

Answer 1

BIG difference. If they are sold while she is alive, she would be subject to paying capital gains tax if she sold the properties at a gain. Being rental properties, she has more than likely taken depreciation against the cost of buying the properties, and her adjusted cost basis in them may not be much depending on how long she has had them. She would be taxed on the gain between the adjusted cost basis and what she sold them for, and would be taxed at long-term capital gains rate if she owned them for more than 1 year (maximum rate is 15%, and tax on recapturing any accelerated depreciation would be 25%). If she still owns them when she passes away, the properties would become part of her estate, and if the estate exceeds the federal limit for that year ($2,000,000 for 2007) the estate would pay estate tax. I don't know what state she lives in, so can't tell you regarding any estate taxes for the state. As part of the estate the properties would be valued as to what they were worth upon her death rather than their adjusted cost (this is called a "stepped-up basis"). If the properties were sold after that point capital gains would be based on the difference between the selling price and the "stepped-up basis". Also, inherited property (which is what they would be) automatically become long-term gain, even if sold 1 minute after inheriting them. So depending on what the $$$ value of her estate would be it would quite possibly be better for her to hold onto the properties and have them be sold after her death.

Answer 2

MAJOR difference! If she sells them now, she'll pay capital gains taxes on them. Depending upon how long she's owned them her basis could now be near zero due to the depreciation recapture rules.

If she leaves them to you in her will, you will acquire the stepped up basis upon her death and if you sold it for that amount there would be no tax due at all.

There's a separate issue of Estate taxes as well. If her estate is worth more than $2 million (for 2007, it's scheduled to change a LOT over the next few years) there will be estate taxes due. Those are paid by the estate but may require the sale of some or all of the assets to pay the tax man. State estate and inheritance taxes can have a major impact as well.

Answer 3

Everybody so far is right on in the correct DIRECTanswer to your question.

However, there is another equally important question that Mother-in-Law might ask....If she is truly miserable (ie not just complaining) does the difference in tax justify the misery?

This is a variation on the theme of "Spending a dollar I would otherwise not spend to save a quarter in tax".

Nobody but her can answer that question.

One other thought: she can do a tax deferred (Sec 1031) exchange of her residential rental properties for commercial properties or bare land held for speculation. The first will reduce her management problem, the second will eliminate them. ANd when she dies, you will still get the stepped up basis on the replacement properties.

Answer 4

my question: does it make any difference tax-wise whether the properties are sold now while she's alive or by us after she dies?

Yes. She would owe cap gain tax (15%) on the gain, which is the difference in the sales price and her basis. Her basis in her purchase price plus improvements less depreciation.

If she took accelerated depreciation should could have some of it recaptured at ordinary income tax rates.

After her death, when it is transferred to you and your siblings, you will get a "step up" in basis to the FMV used in her estate. If her estate is greater than $2million (2007) then her estate would owe estate tax at a rate of 45%.

If you sell your interest after her death, you will only be taxed on the difference between the sales price and your "stepped up" basis.

Answer 5

I don't think it is going to make a difference. I believe that once it is legally owned by you and it is sold, all capital gains are on you.