Ordinary loss: extraordinary tax deduction
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Dear Tax Talk,
My mother died three years ago and left her home as an inheritance for my four siblings and myself. The home was probably worth about $400,000 at that time. We sold it last week for $309,000. Does each of the five children who inherited the home qualify for a tax loss deduction? How do we determine the fair market value of the home three years ago? There was no debt on the house. I would imagine with the crumbling real estate market, this is a bigger issue than it has ever been. Thank you for your help.
You’re probably right that this situation is widespread. When you inherit a house, your basis in the asset is stepped up to fair market value at the time of the decedent’s death — in other words, the home is valued as of when your mother died.
The stepped-up basis is later used for determining the gain or loss. Since fair market value doesn’t allow for a home’s selling expenses, it’s not unusual to incur a loss on the sale of an inherited property. However, in your case, the loss is from more than just the selling expenses. It’s a result of the market downturn, which reduced the value of the home.
Whether the loss is deductible depends on what function the house has had since your mother’s death. If the property had been rented or vacant, and listed for sale most of the time, then you probably have a deductible tax loss.
But if you or your siblings had been using the home personally, then the loss is probably personal and not deductible. A reasonable amount of personal use is expected, of course, to sort through Mom’s affairs. However, if one or more family members had been using the property as a principal or second residence, the loss probably would be considered personal.
If the home had been rented, then your loss could be ordinary under Section 1231 losses. Ordinary losses can offset other income including that from salaries, investments or other businesses.
Otherwise, it would be a capital loss. In that case, the loss would be divided among the five children. The difficulty here is that a capital loss is limited to an offsetting capital gain — plus an additional $3,000 deduction for each sibling for losses in excess of gains.
For example, if the loss is $100,000, each sibling has a $20,000 capital loss to report against offsetting capital gains. Each sibling is also entitled to claim the $3,000 deduction for capital losses in excess of capital gains. (The $3,000 limit is per person, and is not applied to the transaction as a whole.)
Ordinary losses can also be used to offset capital gains. So generally speaking, it is far better to have a loss classified as ordinary. As a deduction, it is far more versatile.
You and your siblings will need to determine your exact loss for tax purposes. While the Internal Revenue Service does not require you to have an appraisal, you need to make a good estimate of the value of the house at the time of your mom’s death. Between research organizations like Zillow and your real estate agent, you should be able to come up with something to substantiate the market decline since your mother’s death.
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