Q. My mother-in-law put her home in a family revocable trust fund. She took out a reverse mortgage to pay for home health aide. She passed away in 2010. The trust fund became Irrevocable upon her death. We couldn't sell the house, so all five siblings paid off the reverse mortgage (checks were written to the family trust fund). The house was appraised at $300,000 when reverse mortgage was taken out six months before her death. It has now appraised for $279,000. If/when the house sells, do the heirs pay capital gains tax on all the money that is distributed? Or, does each sibling get to deduct the amount that was paid toward the reverse mortgage first? Cathy, Roseville, CA
The first question that has to be addressed is will there be a gain or loss on the sale of the residence. In order to answer that question, you have to know two things: what is the income tax "basis" of the residence, and how much are the sales proceeds (net of selling expenses)?
The tax basis of property inherited from a decedent is usually the fair market value as of the date of the decedent's death. Assuming that there was not a significant decline in value between the date of the appraisal for the reverse mortgage and the date of your mother-in-law's death, the basis indicated by the appraisal would be $300,000. If you are concerned that there was a decline in value, obtain an appraisal as of the date of death.
Assuming a sales price of $279,000 and selling expense estimated at 7% of the sales price, the net sales proceeds would be about $259,500. That being the case, the residence would have sold for a loss of about $40,500 (the amount by which the basis of $300,000 exceeds the net sales proceeds of $259,500). Assuming no personal use of the residence post death by any of the beneficiaries, the loss should be treated as a long-term capital loss. This loss passes out to the beneficiaries upon termination of the trust, assuming no other capital gain income recognized by the trust. So each of the five beneficiaries would report a long-term capital loss of about $8,100 in the above example.
The distribution of the sales proceeds out of the trust would not be taxable to the beneficiaries, based on the above analysis. The residence sold at a loss, so the cash distributed represents a distribution of "corpus" from the trust, If the property had sold at a gain in the year of the termination of the trust, the beneficiaries may have had to pay tax on the gain, but not on their proportionate share of the sales proceeds.
The payment of debts associated with inherited property does not increase the basis, as a rule. By rule of law, the basis is the fair market value of the property as of the date of the decedent's death, in most cases.