Even though it’s the shortest month of the year (even during a Leap Year!), February brings forth many significant milestones. Those of us in the northeast eagerly await the Groundhog’s report hoping for warmer days ahead, many people think of February as the month of love with Valentine’s Day on the 14^th, it is often considered the beginning of the Spring real estate market, and our accountant friends begin to gear up for their busy tax season.

Speaking of taxes, since I continue to hear from clients who are concerned about capital gains taxes if they sell their home, I wanted to re-share an article that we posted a couple of years ago – Capital Gains Taxes on Real Estate Sales.

Since 1997, it is NOT necessary to purchase another primary residence in order to avoid capital gains. The Internal Revenue Code now allows a homeowner to sell a property for up to $250,000 tax-free gain as long as the homeowner lived in the property as their primary residence for at least two years.

This rule can also apply to real estate that is owned by a Trust, but the trust must be written in a specific way to allow the original owner to continue to take advantage of this rule.

If you want to transfer your home to a trust, please be sure to get proper guidance so you don’t inadvertently leave yourself or your children with a large and unnecessary tax debt.

Here are some examples of planning that could result in a large tax debt.

Trying to Avoid Capital Gains by Giving Your Home to Your Children for Asset Protection.

Many people want to try to preserve their estate for their children to inherit. They hear that they can “quitclaim” their house to their children.

While quitclaiming your home to your children starts the 5-year look-back for long-term Medicaid planning purposes, unless your children also live in the home, they do not qualify for the primary residence capital gains exemption.

 

Related Post: Asset Protection Planning Benefits For Medicaid

 

And your lifetime gift to them also means that they take on your tax “basis”, which is the value of the home when you purchased it, plus the value of any capital improvements you made. So when the home is sold, the gain, which would be the difference between the sales price and your basis, is fully taxable to your children.

For example, you and your spouse purchased your home in 1985 for $150,000 and have lived in it as your primary residence since then. Today it is worth $450,000. You have not made any capital improvements, the increase in value is just due to the market. You have a gain of $300,000.

If you and your spouse sold the house, you would have ZERO capital gains taxes because you and your spouse are each entitled to a $250,000 capital gains exemption, for a total of $500,000. Since your gain is less than that, you pay no taxes (even if you do not reinvest the sales proceeds).

In the same scenario, if you quitclaimed the house to your children in 2018 to preserve the home against having to be spent on your long-term care needs and then you decided in 2024 that you wanted to sell and move to a different house or to assisted living, your children, as the owners, would be responsible for paying capital gains on $300,000.

The better alternative: If your goal is to preserve the value of your home for your children to inherit, consider an irrevocable grantor trust that includes provisions to preserve your ability to claim the capital gains exclusion.

This type of planning allows you to begin the 5-year look-back for asset protection purposes while also taking advantage of the primary residence capital gains exemption law.

 

Related Post: Another Reason To Put Your Property In A Trust

 

Trying to Avoid Capital Gains by Giving Your Home to Your Children for Probate Avoidance.

Last year I was asked to do a closing for a gentleman who was selling a home that he owned. In discussing the specifics with him, I found out that the home was his father’s and right before the father died, he quitclaimed the house to the son because he thought that would help the son since he would not have to go through probate. While this is true, the transfer to the son could have caused significant taxes for the son had we not intervened.

As mentioned earlier, when you gift an asset to someone during your lifetime, the receiver of the gift takes on your tax basis (what you paid for the asset + capital improvements). But when that same person INHERITS the asset after your passing, the receiver gets a “step up” in basis to the current value of the asset.

This is because the value of the asset is included in the decedent’s estate tax return at the current value (whatever the fair market value is on the day that the decedent died). So the people who inherit that asset now get it with a basis that is equal to the value of the asset listed on the estate tax return (i.e., the current value).

 

Related Post: How To Avoid Capital Gains Taxes When Selling Your Home

 

If those people then turn around the sell the asset at the same value, they have ZERO gain. So even though they may not qualify for the personal residence exemption, it does not matter because there is no gain.

Luckily in this client’s case, dad had lived in the home until he passed and he had just died a few weeks before the house was under contract. We were able to prepare and file an estate tax return for Dad including the full value of the home by explaining to the Probate Court that Dad had life use.

The other problem with this plan was that the son was not the only child nor the only person that dad wanted to inherit the house. Dad trusted his son to sell the house and share the proceeds with his sisters. Luckily son was trustworthy. Not everyone is and the son could have walked away with all of the proceeds and his sisters would have no legal recourse.

For the son, though, this could have caused tax problems. Now he is giving away thousands of dollars, which not only requires him to file gift tax returns but could cause problems for him if he needs long-term care within the next five years.

The better alternative: If probate avoidance is your goal, consider preparing a revocable trust and transferring your assets into the trust. If an asset is owned by your trust and not in your individual name, it avoids probate.

The value of the asset is still included in your estate, so your beneficiaries receive the stepped-up basis, and the trust instrument can state exactly who should receive a share of the assets so you do not burden one person with having to distribute the assets and cause tax implications for them or worse, that person chooses not to follow your wishes.

 

Disclaimer: The information provided in this article does not, and is not intended to, constitute legal advice and is for general informational purposes only.

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