Many US homeowners saw their net worths surge over the past decade-plus as residential property values rose through the roof. But that financial windfall could trigger troubling tax consequences…and older homeowners can be especially vulnerable. Bottom Line Personal asked retirement expert Robert Carlson, JD, for details.
Capital Gains Housing Tax Bomb
Homeowners typically don’t expect that selling a home will create a capital gains tax bill—that’s because there’s a capital gains tax exclusion for the sale of primary residences. But that exclusion has not kept pace with rising home values—it was set at $250,000 ($500,000 for married couples who file their taxes jointly) nearly 30 years ago, and that’s where it remains to this day. A recent bill called the More Homes on the Market Act that would have doubled the exclusion’s size failed to become law.
People who purchased their homes more than a decade ago and/or who live in parts of the US where home values are especially high could easily generate capital gains well in excess of $250,000 or $500,000 when they sell, even if those homes are ordinary middle-class residences, not mansions. These homeowners could end up saddled with big, unexpected tax bills.
Six potential strategies for home sellers in this situation…
- Sell laggard investments during the year of the home sale. Most stock market investors are aware of tax-loss harvesting—if you sell shares that have fallen in value, you create capital losses that can be used to offset the capital gains generated by more successful investments, lowering your net gain and thus your capital gains tax bill. That same sell-declined-investments strategy can be used to offset a taxable capital gain created by the sale of a home.
- Total up your capital improvement costs. Calculating the capital gains generated by a home sale isn’t as simple as subtracting the amount originally paid for the home from the amount it eventually sells for. Additional amounts that the homeowner paid over the years to improve that home also can be added to the home’s basis, reducing or eliminating any taxable capital gain. Many homeowners haven’t kept careful track of their home-improvement costs because they didn’t expect to face capital gains taxes when they sold the home. Fortunately, these costs often can be reconstructed even years later by digging though old files, reviewing old bank records and/or asking contractors to check their old billing records.
Important: Bills for home maintenance and repairs are not considered capital improvements and cannot be used to reduce capital gains. A capital improvement is something that adds long-term value to the home, such as finishing a previously unfinished basement, adding an addition, paving a previously unpaved driveway, having a fence installed or updating an old electrical system. Fixing home components that have broken or worn out doesn’t count. See IRS Publication 523, Selling Your Home, for details.
- Leave the property to your heirs. If you don’t sell your home and instead leave it to your heirs, you won’t face capital gains taxes on it—and they probably won’t either…at least in any meaningful amount. Heirs typically receive a step up in basis on inherited property—they calculate the capital gains by subtracting the fair market value of the property at the time of the prior owners’ death from the amount they sell it for. In other words, they probably won’t have to pay taxes on capital gains that occurred during the deceased person’s lifetime. Downside: Not selling the home might not be a viable option for homeowners who need money to pay for retirement or purchase a different property.
- Sell the home in an installment sale. In this arrangement, the buyer pays for the property slowly over the course of many years, rather than up front as is typical. While doing this won’t reduce the overall taxable capital gain of the home, it will divide that gain up over many years, making the resulting taxes easier to pay. Downside: Some installment-sale buyers fail to make all the contractually required payments, forcing sellers to foreclose on them. The consequences of repossessing or foreclosure depend on the details. It is likely there will be a gain or loss to the lender/seller on the foreclosure. Then the new tax basis of the property usually is its fair market value on the date of the foreclosure. But it depends on the details, so it is best to talk with an accountant or real estate attorney.
- Put the home in a charitable remainder trust. With this strategy, a trust is created and takes possession of the home. That trust then sells the home and pays the former homeowner income for the remainder of his/her life. Assets remaining in the trust after the property owner’s death pass to a charity of his/her choosing. This provides a trio of potential tax advantages—there are no capital gains taxes on the home sale…there’s a tax deduction for the value of the charitable gift…and the home doesn’t create estate taxes for heirs. Downside: Neither the home itself nor the money generated by its sale pass to heirs. You should note that the income payments from the trust will be part tax-free return of principal, part taxable interest and part capital gain.
- Sell within two years of being widowed. The capital gains tax exclusion for single homeowners typically is capped at $250,000, half of the $500,000 exclusion available to married couples filing jointly. But there’s an exception—widows and widowers could still qualify for the full $500,000 exclusion as long as they sell the home within two years of their spouses’ date of death and haven’t yet remarried.
Warning: The capital gains tax exclusion is available only on principal residences. If you split your time between multiple homes, there’s a chance that the property you consider your primary home might not qualify. Your principal residence generally is the home where you spent the majority of the year, though other criteria occasionally come into play as well. If you have multiple homes, consult IRS Publication 523 or speak with a tax attorney before putting your home on the market. If the property does not currently qualify as your principal residence, there might be a way to make it qualify for this valuable tax exclusion before selling.
Property Tax Housing Tax Bomb
Another downside of rising home values—rising property tax bills. Property taxes typically are assessed based on a percentage of property value, so when the value of a home skyrockets—as they have over the past decade-plus—property tax bills skyrocket, too. In fact, property taxes in many areas have risen even faster than home values, as municipalities increase property tax rates to cover ever-rising local government budgets. Steep property tax increases can be especially problematic for older homeowners, many of whom are on fixed incomes. It isn’t easy to reduce property tax bills without selling the home and relocating, but there are a few potential options…
Consider appealing your property tax assessment
Your local government might be calculating your property tax bill based on an inflated valuation of your home. Tax assessors don’t actually inspect most properties—they base their assessments on information they have on file for the property, such as building permits. You can review the information your town or county has on file for your property—this info usually can be accessed online through the town or county’s website, though in some areas a visit to a government office is necessary. If you discover something inaccurate in this info, an appeal might successfully lower your property taxes—assuming this error is something that inflates the value of your home, such as overstating its square footage or number of bathrooms. (Don’t appeal if you discover errors that make your home seem less valuable than it really is, or you could accidentally inflate your tax bill.) An appeal also might be successful if your home has a serious problem that makes it less valuable than other homes that are superficially comparable. Your local assessor’s office can provide details about the appeals process in your area.
Check if your state has a property tax relief program for seniors
Some states and municipalities let older homeowners defer the payment of their property taxes until they sell the home or pass away. Program details vary by location, but typically homeowners must be in or beyond their 60s to qualify, and there often are income caps or additional restrictions as well. Most but not all of these programs impose interest on these tax deferments, though the interest rates often are relatively low. Contact your municipality’s assessor’s office to ask if any such program is available in your area and, if so, where you can find details. Downside: These programs only defer taxes—they don’t permanently reduce them.
