Many residential real-estate markets are recovering. Some are booming. That means more people, especially seniors, have homes that have substantially increased in value. If you fit into this category, please don’t sell without considering the heavy tax hit that would result. Here are the details — and a tax-saving strategy to consider.
Hugely-appreciated home sale basics
If you sell a principal residence that is worth much more than you paid for it, your profit will exceed the federal home sale gain exclusion. That means part of the profit will be taxed as capital gain (unless you have offsetting capital losses). The maximum exclusion is $500,000 for married couples and $250,000 for singles.
If you sell this type of home and it is not your principal residence (like a vacation home), you get no gain exclusion break. So the entire profit will be taxed as capital gain (unless you have offsetting capital losses).
Example: You and your spouse bought your home many years ago for $300,000. Over the years you made $200,000 in improvements, so your tax basis in the property is $500,000 ($300,000 + $200,000). If you sell the place, you would net $3 million. Your Form 1040 would show a whopping taxable gain of $2 million ($3 million sale price - $500,000 basis - $500,000 gain exclusion).
If the same numbers apply to a vacation home, selling would trigger an even-more-whopping $2.5 million taxable gain ($3 million sale price - $500,000 basis), because there’s no gain exclusion break for vacation homes.
A big tax gain is one thing. The actual tax hit depends on the applicable tax rate.
Federal Capital Gains Tax: Under the current rules, the maximum federal long-term capital gains tax rate is 20%. That maximum 20% rate will apply to huge taxable gains from home sales.
3.8% Medicare Surtax: Folks with huge home sale gains will also owe the 3.8% Medicare surtax on net investment income, which is defined to include the taxable portion of gain from selling a principal residence and gain from selling a vacation home.
State Capital Gains Tax: Most states that tax personal income also tax capital gains — including taxable home sale gains — at the same rates as ordinary income. If you live in California, where many of these homes that have soared in value happen to be, the maximum state income-tax rate on capital gains is a whopping 13.3%. If you live in New York City, the maximum combined state and city income-tax rate is 12.9%. Other jurisdictions have lower rates, but state tax bills can still be substantial. (If you live in a state with no personal income tax, congratulations: you only have to worry about the federal tax hit.)
Adding the rates up
If you have a whopping home sale gain, the federal tax hit could be as high as 23.8% (20% capital gains rate + 3.8% Medicare surtax).
If you live in California or New York City, the state and local tax hit on such a home sale gain could be around 13%, which would amount to a combined federal, state and local tax rate in the 37% range. Now do the math on a big taxable home sale gain. Yikes!
While tax rates in other states are lower, they can still be painful.
The tax-saving solution: Hang on until the bitter end
The basic tax-saving strategy in the hugely-appreciated home scenario is to do nothing. Hang onto the home. Don’t sell it! Here’s why. For federal income tax purposes, the tax basis of the portion of a personal residence that you own is stepped up to fair market value (FMV) as of: (1) the date of your death or (2) six months after that date, if the executor of your estate so chooses. Source: Internal Revenue Code Section 1014(a).
- If you’re the sole owner of your home, the basis step-up rule applies to the entire residence after you die. When your heirs sell the property, federal capital gains tax will only be due on the additional appreciation (if any) that occurs after the magic date.
- If you and your spouse own the property together, the tax basis of the portion you own will be stepped up when you die. The tax basis of the remaining portion will be stepped up when your spouse dies. Once again, your heirs will probably owe little or nothing to Uncle Sam when the property is sold.
- If you and your spouse own the home as community property in one of the nine community property states (one of which is California), the tax basis of the entire residence is generally stepped up to FMV when the first spouse dies — not just the half that was owned by that person. This weird-but-true rule means the surviving spouse can then sell the place and owe little or nothing in federal capital gains tax. Source: Internal Revenue Code Section 1014(b)(6).
- If these taxpayer-friendly basis step-up rules also apply in your state, the hang-onto-your-home strategy will work the same tax-saving magic for state income tax purposes.
The bottom line
Doing nothing is not usually a great tax planning strategy, but this scenario is an exception. One more thing: if you think you can’t afford to hang onto your hugely-appreciated home until the bitter end, consider taking out a reverse mortgage to get the cash you need. The interest and transaction costs of a reverse mortgage could be a very small fraction of the tax cost you would avoid by hanging onto your hugely appreciated home.