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Rising Home Values Can Make Home Ownership More Taxing

(RIVERWOODS, ILL., January 2005) – While the 1997 tax law change allowing individuals to exclude up to $250,000 in capital gains on the sale of a personal residence (and married couples up to $500,000) was hailed as significant tax relief for homeowners, seven years later, not everyone is finding it brings as much relief as hoped for – particularly long-term homeowners in a healthy real estate market, according to CCH INCORPORATED (CCH), a leading provider of tax and accounting information, software and services (tax.cchgroup.com).

"Being able to exclude $500,000 from capital gains generally has been plenty, but for older couples, particularly if a spouse dies or for those living in fast-appreciating areas, there is still an increasing likelihood they’ll owe capital gains on some portion of the sale of their home," said John W. Roth, JD, federal tax analyst for CCH.

One way some taxpayers are minimizing the burden is by undertaking like-kind exchanges on rental property and then converting the property into a personal residence.

Below, CCH takes a look at some of the tax consequences of home ownership and issues regarding capital gains on the sale of a home.

One way that some landlords are reducing capital gains is by using like-kind transactions, exchanging one rental property for another rental property and then subsequently turning the second rental property into their personal home. Whereas homeowners can exclude up to $500,000 in capital gains, no such exclusion exists for income property, meaning that all gain would be taxed.

With like-kind transactions, however, assuming the two rental properties are the same price, there is no gain and a couple simply transfers the adjusted cost basis of the first rental property (what they paid for the property plus permanent improvements, less depreciation taken for income property) to the second rental property. After they convert the rental property to their home and later sell the home, they may be eligible for the $500,000 capital gains exclusion.

The difference between selling a rental property and purchasing a home versus a like-kind transaction can mean the difference in taxes owed on thousands of dollars in capital gains. As with other investments, long-term capital gains on a home are taxed at 15 percent for taxpayers in the 25-percent and higher tax brackets and at 5 percent for those in the 10-percent and 15-percent brackets.

Any depreciation taken after May 6, 1997, must be recaptured as ordinary income not eligible for the capital gains exclusion or reduced tax rates. There are still significant tax savings, however. The following two scenarios illustrate this:

Scenario 1

Anne and Mike Reilly own a three-flat with a cost basis of $500,000. They sell the flat for $800,000, realizing a gain of $300,000, on which they must pay taxes. Their capital gains rate is 15 percent, so they owe $45,000. Then, they purchase a single-family home that they sell five years later for $1 million. Their basis in the home is $800,000, so they have a gain of $200,000. They qualify for the $500,000 capital gains exclusion, so they pay no capital gains on the home. They had, however, paid $45,000 in capital gains taxes on the three-flat.

Scenario 2

Anne and Mike Reilly choose to do a like-kind exchange of their $800,000 three-flat for a same-priced single-family home currently being rented out. Because it’s an even exchange, there are no capital gains, saving them the $45,000 paid in Scenario 1. However, rather than $800,000, their basis in the home is $500,000, carried over from the adjusted basis of the three-flat. They rent the single-family home for two years and then decide to make it their personal residence. While it’s their residence, they make $50,000 in improvements, increasing their basis to $550,000. Three years later, they sell the home for $1 million, for a gain of $450,000. With a capital gains exclusion of $500,000, they pay no capital gains taxes on the like-kind exchange, and they managed to save $45,000 in capital gains taxes by using a like-kind transaction versus selling the three-flat.

While the tax savings can be significant, there are some catches: First, the exchange must be between two business properties, so both properties initially would have to be rentals. Second, the Reilly’s would have to continue to rent the second property for a period of time before converting it to their home. Finally, they would have to own the home for a minimum of five years before selling to be eligible for the $500,000 capital gains exclusion.

"Many tax practitioners advise at least two years of rental before conversion to avoid the IRS questioning the like-kind exchange. The IRS has issued no clear guidance on this," said Roth. "If challenged, the IRS could disallow the like-kind tax treatment, making the individuals responsible for paying back capital gains taxes along with penalties."

Knowing basis and keeping track of major improvements so that the basis can be increased over time can mean significant savings for anyone. This is particularly important for older couples who have lived in their home for decades. In this case, when one person dies, he or she likely leaves the other with a highly appreciated home and a reduced capital gains exclusion.

While a couple can exclude up to $500,000 in gains when they sell their home (assuming they’ve owned it for five years and one spouse has lived in it at least two years), a surviving spouse, as any single person, can only exclude up to $250,000 in gains on the sale of the home.

Determining the gain requires knowing the basis, which steps up when one spouse dies, and how much it steps up depends upon when the home was purchased. If the home was purchased before 1977 with the deceased having contributed all of the original purchase price of the residence (or at least there is no evidence that the survivor made a contribution) and all of the date-of-death value was included in the deceased’s gross estate, then the surviving spouse receives a step up in basis for the entire fair market value of the home at the point the spouse died.

Under the current rule for spousal joint tenancies, only one-half of the value of joint property is included in the gross estate of the first to die, regardless of which spouse purchased the home. Under this rule, the survivor gets a step up in basis for only the deceased’s half of the property.

For example, a couple bought a home in 1982 for $80,000 and has made $20,000 in allowable improvements bringing their basis to $100,000. The husband dies in 2005, at which time the home’s fair market value is $600,000. The widow’s stepped-up basis becomes one-half the $100,000 (or $50,000) basis and one half the fair market value of $600,000 (or $300,000), equaling $350,000. The widow lives in the home for 10 more years, during which time the home continues to appreciate, and she then sells it for $900,000. Her stepped-up basis in the home is $350,000, and her gain is $550,000. She is able to exclude $250,000 in gains, but owes taxes on the remaining $300,000.

Had the same scenario occurred, but the home had been purchased five years earlier, in 1975, then the widow would have been able to step up the basis to the fair market value of $600,000 in the year her husband died. When she went to sell the home 10 years later for $900,000, her gain would have been $300,000, with $250,000 excludable, meaning she would have to pay taxes on just $50,000 of gains.

A surviving spouse can minimize capital gains tax liability by selling the home in the year in which they became a widow or widower, allowing them to file married, jointly and claim the full $500,000 exemption.

"Many surviving spouses living in the original family home are truly land rich. They’re sitting on a sizably appreciated piece of real estate that has the potential for a surprisingly sizable tax debt when they go to sell it," said Bruno Graziano, JD, CCH estate tax analyst. "For this reason, it’s not uncommon for advisors to counsel a new widow or widower to consider selling the home the same year the spouse dies if the surviving spouse does not have long-term plans to live in the home."

In community property states (such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), the surviving spouse is regarded as acquiring the community property from his or her deceased spouse, therefore, the surviving spouse gets a stepped-up basis to the current fair market on the entire home.

In addition to widows and widowers being able to claim the full $500,000 exclusion (versus the individual filer’s $250,000) if they sell the home in the same year that their spouse dies, other exceptions to the exclusion rule include:

Incapacitation – If someone becomes incapacitated but has lived in his home for one year during the five years before the sale, he also can count the time spent in a licensed facility (such as a nursing home) for the purpose of meeting the two-year test.

Military Duty – Under the Military Family Tax Relief Act of 2003, members of the military are able to claim the exclusion by excluding up to 10 years of active duty away from home in calculating their eligibility.

Hardship – People qualifying for hardship relief are entitled to a reduced, pro-rata exclusion if a change in employment, health or unforeseen circumstances (e.g., death, loss of a job, divorce or legal separation and multiple births from the same pregnancy) keep them from meeting the two-year ownership requirement.

Portion Not Used as Principal Residence – Taxpayers are not allowed to claim the gains exclusion for property that is used for nonresidential purposes. If the personal and non-personal use is within the same dwelling unit – for example a home office – no allocation of gain is required. However, you do have to recapture any depreciation taken on the home office. If the business use is in a separate building – for example an art studio in a barn – you’re required to allocate basis separately between the principal residence and nonresidential property.

When the $250,000 and $500,000 exclusions became law in 1997, the initial thought was that homeowners would no longer need to hang on to their receipts in attempts to use home improvements to increase their basis. That proved nearsighted, however, and most advisors now urge homeowners to record all major improvements to their home.

Among the improvement costs that can be used to adjust basis are room additions as well as adding a garage, deck or porch; landscaping and grounds improvements, such as new drives, walks and fences; heating and air conditioning systems; new septic systems and water heaters; modernizing kitchens; adding built-in appliances and new flooring; insulation and new windows; wiring improvements and security systems; and a new roof. However, the rule also says they need to be permanent, so if you lived in a home for 20 years, put up a fence the first year you lived there and then replaced that fence the year before you sold, you could only factor in the cost of the final fence.

Costs that can’t be used to increase basis include general maintenance such as repainting your house, fixing leaks or replacing broken windows.

CCH INCORPORATED (tax.cchgroup.com), based in Riverwoods, Ill., is a leading provider of tax and accounting information, software and services. CCH has served tax, accounting and business professionals and their clients since 1913, providing them with the most authoritative, timely and comprehensive tax resources. CCH is a Wolters Kluwer company (www.wolterskluwer.com).

Wolters Kluwer is a leading multinational publisher and information services company. The company’s core markets are spread across the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2003) of €3.4 billion, employs approximately 18,750 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its depositary receipts of shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices.

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