Basis of inherited home with postponed gain

My wife and I have postponed gain from our previous home that we sold in 1994, under the law in effect at that time that allowed the gain to be postponed. We filed Form 2119 with our 1994 tax return. I know that if we sell our current home the basis would be reduced by the amount of the postponed gain.

Suppose we don't sell, our adult children inherit our home after both of us die, and the kids then sell the home. Assuming that stepped-up basis is still in effect, would the kids' basis be the full fair market value on the date that the second one of us died? Or would the kids have to subtract the gain that we postponed on our previous home?

The kids never postponed any gain. My wife and I postponed the gain. The postponed gain reduces our basis. Does it reduce our heirs' basis?

Is the answer different if our estate sells our home and distributes the proceeds to the kids, instead of letting the kids take ownership of the home and sell it?

There are only two homes involved here: the one we sold in

1994, and the new home that we bought in 1994 and still own and live in. There has never been any business use or rental use of either home, so there is no depreciation.

Bob Sandler

The only thing that matters "today" is your current basis in your home. That would be the purchase price in 1994 less the deferred gain from your earlier home sale plus/minus any improvements added/removed from the property since 1994. If you don't sell and the house passes to your estate or children, the basis will be stepped up to the FMV on the date of the second-to-die's death. (There will be an intermediate step-up at the first death, but the details will depend on whether or not you are in a community property state.) The deferred gain from the earlier sale will "vanish" the same as if you die with appreciated stocks.

Generally speaking, it doesn't matter whether the estate or the heirs sell since a sale near the date of death should result in a small loss (transaction costs). But if the sale results in a gain, the income threshold for 20% LTCGs is much lower for an estate than an individual.

Ira Smilovitz, EA