For decades, I’ve used the phrase “swap ’til you drop” to explain the benefit of using 1031 exchanges to legally avoid taxes on sales of real estate. The drop part refers to the step up basis property receives in the hands of the heir. It essentially wipes out the accumulated profits at the time of death and is what I have always called the “ultimate escape from capital gains taxes.”

Because estate taxes are generally higher than capital gains taxes, for those whose estates are large enough to exceed the tax free threshold, there are often benefits to using lower step up values, when that is possible.

When it comes to the $250,000 per person tax free exclusion of gain from primary residence sales, I have been seeing a lot of confusion, such as this email I received yesterday.

Hi. I just came across your website. I have a question you might be able to answer. I have a client who’s husband died 6/25/03. She filed married joint for 2003 but for 2004 of course she will file single. She is selling their primary residence in 2004. Will she only be allowed the $250,000 maximum tax exclusion since she is single filing status for that year? Or do you know of any special rules about spouses of deceased taxpayers getting a longer period to sale principal residence and still claim the $500K. Please let me know if you know anything about this or if you know of a place I can research it. Thank you.

My response:

Noting that you are in Vacaville, I need to mention that if your client is also in California, the entire gain in the home prior to 6/25/03 has already been wiped out by the stepped up basis the widow receives. For community property, the entire cost basis is stepped up.

If your client is in a non-community property state, the husband’s half of the property is stepped up to half of the home’s FMV as of 6/25/03 and the widow’s half remains as it was before.

Your client will only have to worry about the appreciated value since 6/25/03, which can then be excluded on a pro-rated basis of $10,417 ($250,000 / 24 months) of tax free gain per month from 6/25/03 until the date of sale. The death is one of the circumstances that allows the use of the pro-rated exclusion.

You can see this explained on Pages 7 & 8 of IRS Publication 523, which covers home sales.

Good luck. I hope this helps.

You can see all of the rules for the sale of a residence by obtaining IRS’s Publication 523. This is available from the IRS website in downloadable PDF format and in browser friendly html.