Sunday, January 24, 2016

Take a loss on an inheritance? Not likely.

If you inherit a house, do you owe taxes on it?  If you sell it for a loss, do you get to deduct that from your taxes?

I can see on Blogger what inquiries find this blog.  Some are rather fascinating, such as this one that came across the transom today:
"I inherited house worth $400,000 but can only sell it for 250,000"
Answer:  The house is only worth $250,000.   You may think it is worth $400,000, but the market is saying otherwise, by the fact you sold it for less.

We went though this recently selling a house belonging to a parent, that we thought was worth well over $600,000 but fetched only $450,000 on the open market.   Families tend to do this a lot - thinking that Mom and Dad's house is worth a fortune.  It is part of a natural tendency to over-value things we own, and under-valuing other people's things.

The fair market value is what you get for it when you sell it, not what you think it is worth.

Now in our case, divided by three, this was a nice windfall, but hardly a game-changer in our lives.   And if you think $150,000 is a lot of money, well, it ain't.   It is barely enough to live on for three years, for the average family.

Again, calculating capital gains isn't hard.   You take your sales price (Amount Realized, or AR) subtract your "basis" (Adjusted Basis, or AB, which is generally, what you paid for it) and the difference is your gain G, or profit, which you pay tax on. 

G = AR - AB

For an inheritance, AB is the "fair market value" at the time of death, so in most cases, G=0 as what you sell the house for, shortly after you inherit, is in fact the fair market value of the home.  You pay no taxes on the inheritance, which is the biggest tax "loophole" there is.   Note that the dead guy you inherited from may have to pay taxes (the gift and estate tax) but that doesn't kick in, until his estate is worth millions.   So folks like us have nothing to worry about, when it comes to a "death tax".

Now, if you kept the house, and rented it out (hopefully at a monthly profit) for ten years, and then sold it, you might have a real gain.   For example, at the time of death, suppose you have the house appraised for $250,000.   You rent it for ten years, and sell it for $600,000.   You now have a gain of $350,000, the Amount Realized minus your "stepped-up basis" at the time of death.

And yea, the IRS has ways of calculating your basis, and you can calculate it by having an appraisal done at the time you inherit, or even an "historical appraisal" done years later, of what it would have been worth at the time of death.   Be prepared to document this, though, for Uncle Sam.

But if you rented the house out, you may have chosen to depreciate the property on your taxes, which only means that you took a standard portion of the Basis off your income each year, which in turn lowered your income tax burden.   Say you depreciated over 10 years (consult a tax adviser for details) and thus deducted $25,000 (10%) from your income each year (sweet!).  Your basis is now ZERO, as this depreciation is deducted from your basis ($25,000 x 10 years = $250,000).   We call this "Adjusted Basis" or AB.  And this house would be "fully depreciated" at this point.

So now, you sell for $600,000 years later, you owe capital gains tax on the whole $600,000.   Ouch.

And yea, I've "been there, done that" when I sold my office building for $680,000 after renting it out for a decade.   A nice profit, but the taxes due were on the entire sale price not just the difference between the sale price and what I paid for it.

It sounds bad, until you realize that 15% capital gains tax beats the snot out of 38% ordinary income tax - plus you delayed paying the tax by a decade!  You've converted ordinary income into capital gains, reducing your tax burden and delaying it.  Now you understand why so many people bought Real Estate like mad in the 2000's.  It was a tax shelter.

But getting back to our reader, I think his real question is, "Can I take a loss on the sale of the house?" and that gets very tricky.   If you sold the house right after you inherited it, or shortly thereafter, odds are, the answer is NO, you can't.  Just because you think it is worth $400,000 doesn't make it worth $400,000.   And the actual sale at $250,000 sort of trumps your wishful thinking.  Again, living in reality, here.

For a long-term loss, this may be easier to show, again, with proper documentation such as a historical appraisal.  For short-term sales, this is almost impossible.   Yes, technically, you can show a "loss" on an inherited property.   Doing so realistically is kind of hard.  Think about this for a minute.  You have inherited a quarter-million dollars tax-free.  But that ain't enough for you.  You want to claim this represents a loss to you.   Like my old tax professor used to say, "Pigs get fat, hogs get slaughtered" when it comes to the IRS.

Showing a "loss" in a manner which satisfies the IRS is tricky.   For example, with our situation, we inherited (along with two siblings) a house that "everyone in the family" said was worth $680,000 if not a million dollars.   We cleaned it out, had some work done to fix some broken things and then put it on the market at that price.

Well, six months later, not even one showing.  We lowered the price again and again, until we got an offer at $480,000.   So we took that.  That pretty much was the fair market value of the home.  Fair market value isn't what you think it is worth or what some paid appraiser said it was worth.  It is what a real buyer, "willing and able" will pay for the property.   Reality trumps fantasy, every time.  An actual sale beats wishful thinking, every time.

Why was the home worth less than we thought?  Well, with Florida's crazy "homestead" tax rules, the new owner is looking at a $10,000 property tax bill, if not more.   Our late relative was paying $2500 a year.   Throw in about $5000 in fire, flood, and hurricane insurance, and you are paying $1200 a month on top of whatever mortgage payment you have.

And since the zoning people clamped down on doing a "blowout" to make it into a three-story mini-mansion, the value of the property to a developer is far less.   We were sure a developer would knock it down and start over.  There were no takers.  Instead, a retired couple bought it to live in, doing minor remodeling projects to update the house.

Could we have taken a "loss" on the property?  No, likely not.   You see, a sale within a year or so of the inheritance pretty much sums up what the market value is of the property.   The IRS will tell you this, no matter how many paid appraisals you get (and we paid for one, believe me!).   And if you try to claim this loss on your tax return, without some serious documentation, you will likely get audited and nailed with back taxes owed, interest, and maybe even a fine.  Bear in mind the actual sales price will trump whatever appraisal you got on the place.

But this reader question illustrates how weak thinking works in the world.   People want to believe that things they own are worth more than they are because that works in their favor.   And when they can't get the sale price ("my price") for what they think is a rare heirloom, they throw a hissy fit.

To my prospective reader, I would offer this basic advice:  Be happy you inherited $250,000 tax-free.  The represents a quarter-million dollars more than I will inherit from my parents.  Whining that you deserved more is just making you look ugly.   Trying to claim a loss on your taxes?  Well, you deserve, wholeheartedly, the audit you will receive and the back taxes, penalties, and interest you owe.

More American crybabies.

UPDATE:  There are some odd situations where you may be able to declare a loss on an inherited property, but don't get too excited - it amounts to $3000 a year for a few years.

The house we inherited was part of a Trust, and it was inherited back in 2005 when the market was hot.   Since the Mother-in-Law had a life estate, the Trust could not sell the house until she died in 2014.   At that point the house was worth less than in 2005.

However, the difference, divided by three, was only $44,700.   Of this, only about $30,000 is counted by the IRS (as it is a "passive loss") and we can deduct only $3000 a year from our taxes (which at the 15% marginal rate is about $450.  A nice deduction, but not a money-maker.

The losses can be carried forward to the next taxable year where you will get another whopping $3000 deduction.

So, this is not a huge deal, after all.   Consult an accountant for more details and before filing your return!

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