Many older homeowners are facing a problem that a few years ago was considered unthinkable. These homeowners face taxable capital gains on the sale of their homes, despite the generous $500,000 exemption for married couples. The red hot real estate market of the last five years in many areas has pushed many longtime homeowners into the taxable gain range.
Appreciation has been so strong that even homeowners with fairly modest incomes and average homes for their areas could reap gains of more than $500,000 on their principal residences.
Before 1997, a homeowner avoided taxes on gains from a residence by rolling over the gain into a new residence. The tax basis of the old residence was carried forward, so that the gain eventually could be taxed if a new home of equal or greater value were not purchased. Because of the carried forward tax basis and the unrelenting real estate appreciation in many areas (especially on the coasts), people who bought their first homes in the 1960s or 1970s now have gains that over the years total more than $500,000. It is not uncommon for a home to have a tax basis of $150,000 or less and a value of $650,000 or more.
Current law allows an individual to exclude from income up to $250,000 of gains from the sale of a principal residence. This exemption can be used no more than once every two years. Married couples can exclude up to $500,000 of gains from a principal residence every two years. Gain no longer is deferred by purchasing a home of equal or greater value.
Taxpayers with large gains who don’t want to pay part of their home equity in capital gains taxes have a few options.
Option #1 is to take any capital losses you have in other assets and use those to offset the gain. If you’ve been following our investment recommendations, you aren’t likely to have many of these losses. But you might have some longtime investment dogs with sizeable losses to which you’ve been hanging on. This would be a good time to cut them loose. Let the losses offset the taxable gain from selling your home.
Option #2 is to be sure you have detailed records of the cost of each home plus any capital improvements. A capital improvement is added to the cost of a property to get the tax basis. Many homeowners overlooked this in the past because the old rules made it less important to compute the basis accurately. Homeowners assumed they would be able to defer gains indefinitely. Now, computing the basis accurately is important to homeowners who are pushing the tax-free limit.
Regular repairs are not improvements. An improvement is an expenditure that adds value to the home, prolongs its useful life, or adapts it to new uses. A repair maintains the home in good condition but does not add value or prolong its useful life.
Examples of repairs are repainting the house, fixing gutters or floors, and repairing leaks or plastering.
Examples of improvements are adding a recreation room or bathroom to an unfinished basement, putting up a new fence, putting in new wiring or plumbing, and paving an unpaved driveway. An addition to the house also is an improvement.
IRS Publication 523, Selling Your Home, details the difference between repairs and improvements.
Also be sure that your cost basis includes all the allowable costs. Settlement fees and other closing costs that are not related to a mortgage usually are added to the basis. These can include abstract fees, survey fees, legal fees, and transfer taxes. A full discussion of all the items included in the tax basis is in IRS Publication 523. It can be ordered free at 800-329-3676.
Option #3 is to hold on to the property. If the home is not sold, it will be included in the owners’ estates. The heirs who inherit the house get to increase the tax basis to the current fair market value. The capital gains realized during the prior owners’ lifetimes will escape all capital gains taxes. There might be estate taxes due on the property, but those can be easier to plan for and reduce then the capital gains taxes.
If the owners already have decided to move, the house can be turned into a rental property. They could hold it and rent it for the rest of their lives.
Option #4 is to sell it in an installment sale. This will not reduce the amount of taxable gain. But the installment sale will spread the gain over the years the payments are made instead of lumping it into one year. This might make the tax easier to pay. Spreading out the gain also might make it possible to plan ways to reduce the taxes, such as by taking capital losses or increasing deductions each year to offset the gains.
An installment sale means the sellers take a note from the buyers. Some sellers might like the steady stream of income, and the interest might exceed what can be earned on safe investments today. A disadvantage is that the sellers depend on the buyers’ making the regular payments for years. If payments are missed, the sellers have to initiate a foreclosure procedure to get the home back so it can be re-sold. The sellers also are taking the risk that in the meantime the buyers have not maintained the house but have diminished its value.
Some people sell the home on an installment basis to their children as part of an estate plan. That gets the house out of the parents’ estates, gets the parents cash flow from the equity, and transfers the home and its future appreciation to the children. The children must have the cash flow to pay the loan through their own income, gifts from the parents, or from renting the property.
Option #5 is to rent the home for a year, turning it from a principal residence into an investment property. Then, the house can be exchanged tax-free for another investment property. This defers the capital gains taxes again. The basis of the old home is transferred to the new investment property.
If the new property is the home in which you eventually want to live, rent it to someone else for at least a year. That ensures the property qualifies as an investment property and that the gain is deferred. After that you can move into the property and establish it as your residence.
This strategy is fairly tricky. The values of the two properties have to be equal. If the property you sell is worth more than the one you buy, and you receive additional cash or other property as part of the deal to make things equal, then the gain will be taxable to the extent of that money or property received. It also gets tricky if there is a mortgage on either property.
All the rules for a tax-free exchange of investment properties must be met for this strategy to be effective. I recommend working with an attorney who has experience in like-kind exchanges, as well as a real estate broker who knows the ropes. There are many details that must be followed.