Capital gains tax on proceeds from parents home

[Keith Andrews]

I am hoping a BiggerPockets tax guru can help shed some light on things for me.

My wife’s parents added her and her brother to the title of their primary residence in 2008 (because they were paying the mortgage for them). They originally bought the home in 1980 for $100k. Throughout the years they pulled money out increasing their debt on the house to $300K. They just sold the house for $1M. My wife will receive 25% of the proceeds which equates to about $150k after everything. My questions are the following:

1. Will we have to pay capital gains on $150K or 25% of the gain from 100K to 1M? Or would it be the value of the house when she added the title in 2008?

2. Since this house was her parents primary residence (my wife hasn’t lived in the home for 15 years), is it eligible for a 1031 exchange or any other tax shelter?

Thanks!

[Michael Plaks]

@Keith Andrews

Your question is actually more complicated than you expect.

For starters, we need to establish your wife's tax basis (investment) in the house. Let's say that the house was worth $600k in 2008. She acquired a 1/4 interest, or $150k. But what did she pay ? She paid the mortgage for some time. Was it just goodwill towards her parents? If yes, then it does not count. If she was paying their mortgage in expectation of being awarded 1/4 interest - then it does count. 

Assume the latter and assume she paid $25k towards their mortgage. The other $125k of her interest must be a gift from her parents. Her basis in that portion is equal to her parents' basis. Confusing? Yes, indeed. Their basis in the $125,000 gift is calculated as a certain ratio and will be about $20k. Your wife's total basis is $25k + $20k = $45k.

Her gain is not calculated off of the "proceeds after everything" - assuming that your everything includes mortgage payoff. Her gain is calculated off of 1/4 of the sale price, adjusted for closing costs. Ignoring the closing costs for simplicity, her number is 25% * $1M = $250k.

So your wife owes capital gains on $250k - $45k = $205k. 

My calculation is not complete, however. We have not considered what happened with the remaining mortgage in 2008. Did she continue paying it? Did she assume responsibility for 25% of the mortgage? Or for 50% of the mortgage? This will increase her basis, possibly very dramatically, and reduce her capital gain.

If I have not convinced you that you need professional help, then probably nothing will.

As to a 1031 - see @Dave Foster's answer.