Surviving spouses face tough choices on keeping or selling a home, with a two-year window to navigate the financial "widow tax."
After losing a spouse, most widowers are hit with a cavalcade of financial questions that need answers.
For those who own homes, the biggest tends to be whether to sell the family home or stay put.
Given the importance of generational wealth—and the amount of young people banking on their folks to leave them the family home in order to become homeowners themselves—holding on to the home seems to be the common course of action.
But then comes the dreaded “widow tax” to contend with, if you change your mind or you’re forced to sell.
Fortunately, you have some options—and two years to make all the big decisions you need to.
What is the widow tax?
The "widow tax" is what financial experts usually refer to as the federal income tax burden a surviving spouse experiences when moving from a "married filing jointly" filing status to a "single" status.
Also known as the “survivor's penalty,” the surviving spouse has a limited amount of time to make certain financial decisions under the expectations of a married couple.
When it comes to your home, this includes the capital gains tax.
“A surviving spouse may still qualify for the $500,000 capital gains exclusion if the home is sold no later than two years after the spouse’s death, assuming the other requirements are met,” explains Mills.
“After that, the surviving spouse would generally be limited to the $250,000 individual exclusion. So it's not about one isolated tax rule; it's more about the surviving spouse having to make a major decision while the clock is running.”
What to do first
After your loved one passes, the best course of action is to take stock of your overall finances. When it comes to your home, that includes dialing into how much money you pay in housing costs per month.
Do you still have a mortgage? Are you paying HOA fees? And what are the property taxes like in your area?
These are all important questions to know the answers to because having a baseline number of the cost of keeping your home is typically the deciding factor for widows—and again, time is not on your side.
“The worst way this falls apart is if you wait several years to realize the house is too big, or that your cash flow can't keep up with the mortgage, insurance, and maintenance, and then you also miss out on that major tax treatment,” says Mills.
“So you have to understand the expenses that go into it and whether the house is still right for you if you've dropped to a single-paycheck household.”
Planning for the future
As previously noted, the surviving spouse can face a higher relative income tax rate and lower standard deductions after switching from "married filing jointly" to "single" status, even though their total household income has dropped— the most significant of which is capital gains.
Surviving spouses can exclude up to $500,000 of capital gains from selling a primary home if they sell within two years of their spouse's death. After that, it gets knocked down to $250,000.
But the reality is, you’re likely already over the limit as it is as a couple, let alone a single. Today, roughly 1 in 3 homeowners—nearly 29 million households—have built up more home equity than the federal capital gains tax exclusion for single filers protects when they sell their primary home, according to a recent analysis by the National Association of Realtors®. By 2030, that number is expected to grow to 56% of homeowners.
While nearly 1 in 3 homeowners nationwide is already at risk of a surprise capital gains bill, those hit hardest are the owners who’ve stayed put the longest—especially in states where home values have soared the fastest.
Hawaii tops the list. About 79% of homeowners there could be affected by the $250,000 exclusion limit, with an average capital gain over the exclusion of more than $409,000 per household. Washington follows closely, with nearly 65% of owners at risk. By comparison, West Virginia and Mississippi see the least impact, with fewer than 8% of homeowners potentially exposed.
And the dollar impact is just as lopsided. Nationwide, the average potential federal tax bill for over-the-limit homeowners is about $35,000. But in Hawaii, the average homeowner who surpasses the single-filer cap has an additional $409,346 in gain at risk of taxation.
So now, a big decision needs to be made: Even if you can afford to keep the house right now, can you afford to SELL the house when the time comes without losing a ton of money to capital gains.
Ways to outsmart the widow tax
Mills strongly recommends working with an advisor, a CPA, and an attorney to understand all the different avenues you can explore after your spouse has died.
One option to explore is tax loss harvesting. “You can naturally have losses in your portfolio and use those to offset the capital gains on your home,” explains Mills.
The other important piece of the puzzle is the making sure you implement the step up basis.
“When a spouse dies, the deceased spouse’s portion of the home will generally receive a basis adjustment, which can reduce the amount of gain that is ultimately taxable,” Mills explains.
“So you don’t want to look only at the $500,000 versus $250,000 exclusion; you need to understand the home’s adjusted basis as well.”
So, let’s say you bought the house years ago for $200,000. If the house was worth $1,000,000 when your spouse passed away, the IRS will update your starting price to $1,000,000 or close to it, depending on state law.
Lastly, you have the option of selling within the two-year window. In that case, you may want to keep the home in the family and sell it to your children. While this is a completely viable option, it does come with some considerations.
“I'd be a little careful about adding kids in too quickly just for the tax benefit,” adds Mills.
“You can easily start giving away control in the house, you open up exposure to creditors, and it gets messy in any divorce. They can be part of the long-term estate plan, but they shouldn't be added to a home as a quick shortcut without guidance.”