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09/02/08: Dealing with an Inherited House

HOUSING COUNSEL

By Benny L. Kass

Q: I live in Maryland. My father passed away in January, 2008 and I have inherited his townhouse. He had an existing mortgage. I am continuing to make the mortgage payments. I have not notified the mortgage company. I am unable to obtain financing for a home in my name at this time, and was turned down for 2 home loan attempts. If the lender finds out that I now own the house, can they pull the loan? I don't want to lose the house. There was a Will (I was the PR and sole beneficiary) and I had an attorney prepare the deed which was properly recorded in my name. If I sell the home and payoff the mortgage, are there capital gains taxes or other taxes that I may have to pay? It was my father's wish that the house be mine upon his death, yet I am afraid if I notify the mortgage company, they will pull the loan.

A: You have nothing to worry about so long as you continue to pay the mortgage. I suspect there is a “due on sale” clause in the mortgage document that your father signed, which states that the lender can call the entire loan due if the property is sold or otherwise transferred without the lender's consent.

However, back in l982, Congress enacted the Garn-St. Germain Depository Institutions Act, named after its principal sponsors, Congressman Fernand St. Germain (D-RI) and Senator Jack Garn (R-Utah). Among its many provisions, the Act restricted lenders from enforcing the due on sales clause under certain circumstances. According to the law, “a lender may not exercise its option pursuant to a due-on-sale clause upon ..a transfer to a relative resulting from the death of a borrower...”

Since your father's property was transferred to you upon his death, your lender cannot call that loan due, so long as you remain current with the monthly mortgage obligations. I would not hesitate to advise the lender that you are the new owner, and send a copy of the Deed which reflects that you transferred the property to yourself in your capacity as Personal Representative of your father's estate. You want the lender to start sending you the mortgage payment coupons. More importantly, at the end of each year, lenders are required to send their borrowers (and the IRS) a statement regarding the amount of interest and real estate taxes that were paid in that year, and you want to make sure that this statement is in your name and reflects your social security number. Otherwise, the IRS may question as to why you are deducting mortgage interest when they do not have this confirmation from your lender.

It should also be pointed out that there is another important restriction contained in the Act. A lender cannot enforce the due-on-sale clause upon “a transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety”. This means that if two people hold property as joint tenants (or husband and wife hold as tenants by the entirety), on the death of one of the parties, the survivor gets the title and does not have to pay off any outstanding mortgage.

You asked about any taxes that you may have to pay should you decide to sell the house. Here is where the concept of the “stepped-up” basis comes into play. This means that when a person inherits real estate, their tax basis is the value of the house on the date of death. (Note: it can also be based on the value six months after death, but you have to discuss this with your tax advisors).

Here's an example: your dad bought the property with your mother many years ago for $30,000. Your mother died in 2000, when the property was worth $200,000. We have to determine the tax basis of the property. The basis for your mother and father was $15,000 each. In 2000, your dad received the stepped up basis of half of the value, namely $100,000, thereby increasing his basis to $115,000.

When your father died, the house was worth $400,000. If you sell it for that amount, you will not have made any gain, and thus will not have to pay any capital gains tax. Should you sell for a higher price, your gain will currently be taxed at 15 percent for federal tax plus whatever applicable state tax you will have to pay.

If, on the other hand, you decide to stay in the house, you may be eligible for the up-to-$250,000 exclusion of gain (or $500,000 if you are married and file a joint tax return). You must have owned and used the home as your principal residence for two out of five years (or a total of 730 days) before the house is sold, in order to be eligible for this great tax break.

Let's say that you decide to sell the house three years from now, when it is worth $500,000. Assuming that you did not make any improvements to the property – which would increase your tax basis – and ignoring closing costs and commissions which would reduce your profit, you will have made a gain of $100,000 ($500,000- your basis of $400,000).Since that is below the $250,000 ceiling, you will not have to pay any capital gains tax.

Our tax laws are complex, but in your case, it appears that you are a big winner.

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