5. Does the estate contain a principal residence or vacation home with significant value?

These types of assets commonly have a low basis that would result in capital gains tax if sold during life. If held outright until death, the home will be included in the estate and receive a basis adjustment to the fair market value (FMV) on the date of death that will eliminate most of the capital gains tax owed upon a future sale. If sold during life, there is a potential personal residence gain exclusion ($250,000 if single, $500,000 if married).

It may make sense to transfer the home into a qualified personal residence trust (QPRT) to avoid the inclusion of future appreciation in the estate. This strategy freezes the home’s value for estate tax purposes at the expense of forgoing a potential step-up in basis. A QPRT allows the taxpayer to transfer the home into a trust with a retained right to live in the home for a certain term. The retained right to live in the home discounts the value of the gift to the trust, and, assuming the taxpayer outlives the term, the value of the house is excluded from the estate. The transferor must pay FMV rent to continue living in the house once the term has ended.

An estate may also have an opportunity to deduct a loss on the sale of a home when the loss would otherwise be nondeductible by an individual. If the value of the home declines after the date of death, or if a loss is generated due to selling costs, case law (Miller, T.C. Memo. 1967-44, and Watkins, T.C. Memo. 1973-167) supports possible deductibility of the loss since the home is a capital asset held by the estate. This loss may be deductible on the estate’s income tax return and be subject to the capital loss limitation rules.

Despite case law supporting possible deductions, IRS Chief Counsel Memorandum 1998-012 explains that such a deduction is allowed only when the property has been converted to an income-producing property. The memorandum is not authoritative; however, it does provide insight into the IRS’s position and highlights an area of potential scrutiny.

Planning point: It is important to weigh the benefits of transferring a home out of the estate before death versus holding on to it to receive a potential step-up in basis. Use caution when relying on case law in planning, as the IRS has not indicated that it agrees with the outcome of the cases related to deducting a loss on the sale of a residence after death.