Given the current seller’s market, I thought it would be helpful to bring back an article that I posted three years ago. It is about how capital gains relate to real estate sales, but this time with a twist!
Does The Capital Gains Tax Law Still Exist?
How many of you have heard that you have to reinvest the proceeds of the sale of your home into a new primary residence? And that it has to be of equal or higher value in order to avoid paying capital gains taxes?
I know I had heard that law and yet this law was eliminated in 1997, which was the year that I started practicing law and purchased my first home.
So it was something my parents must have talked about and even though it’s been 25 years, we have clients who are reluctant to sell their primary residence because they do not want to get hit with capital gains taxes.
Here’s What The Law Is Today
Knowing it may relieve some of you and allow you to make a move that you’ve been wanting to do for years.
Under the 1997 Taxpayer Relief Act, each person is given an exemption of a $250,000 gain on the sale of the primary residence. This means if a person purchased a home for $100,000 and then sold it 10 years later for $200,000, the full $100,000 gain is excluded from taxation. A married couple filing jointly has a $500,000 exclusion, even if only one of the two owned the property.
Requirements For The Capital Gains Tax Relief
As with every tax exemption, there are certain requirements that must be met to qualify.
- The exclusion only applies to the primary residence and only if the individual/couple resided there for at least two years.
- If the taxpayer took deductions on the home for a home office or otherwise. The full amount of the deductions taken over the course of the ownership reduces the exemption.
At the closing, if you can affirm that you meet the requirements of the exclusion and the full sales price of your home is less than $250,000 (for an individual ) or $500,000 (for a married couple), then the sale does not get reported to the IRS.
If the sales price exceeds the exemption, then the sale is reported to the IRS by the closing attorney. However, this does not necessarily mean that you will owe taxes.
For example, if an individual sells a primary residence for $350,000 and otherwise meets all of the requirements of the exemption, the transaction will be reported to the IRS on a 1099-S. The individual then needs to report the sale on his or her tax return for that year, along with the individual’s cost basis in the property (price paid plus capital improvements).
Another example, if he paid $250,000 for the property, his gain is $100,000. This falls under the exemption and no taxes are owed. If you ignore the 1099-S and do not report anything, the IRS will presume that the sale price is all gain and will bill you accordingly. This is not a pretty bill to receive!
So When Would Someone Have To Pay Capital Gains Taxes?
Last week I had the pleasure of meeting a new client who was referred to me by her financial advisor. The woman scheduled the meeting as the Power of Attorney for her parents, who are both in memory care assisted living.
Back in 2016, Mom and Dad quitclaimed their house to her and her sister. Those who know about the 5-year look-back rule are probably thinking, “Great! It’s now 2022, so the house is the daughters’ free and clear.” But of course, if that were the end of the story, I probably wouldn’t be including it in this article.
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The woman and her sister now want to sell the house. They both have houses of their own to take care of. Mom and Dad are in assisted living so they no longer live there. And the daughters just want to remove one more thing from their plate, understandably so.
The house is technically theirs free and clear to sell and do what they want with. But, since their parents gifted it to them more than five years ago, the daughters will incur substantial capital gains income taxes.
As explained above, every homeowner is entitled to a capital gains exemption of up to $250,000 for their primary residence if they owned and lived in it for more than two years in the five-year period immediately prior to the sale.
This means that if you bought a house in 1960 for $10,000, as these parents did. Then owned it and lived in it for at least two years. And then sold it for $250,000 in 2022, you would not owe any capital gains taxes because the gain of $240,000 is less than the exemption you are entitled to.
But in this case, the daughters have not lived in the home since they took ownership. And the parents are no longer the owners because they deeded the house to their daughters. Neither is entitled to the personal residence exemption.
Further, since the parents gifted them the house during their lifetime, the daughters take on the parents’ basis. Which is the amount they paid for the property plus the value of capital improvements. In this case, the parents paid $10,000 and the daughters have no record of the value of capital improvements.
If the daughters sell the house now for $250,000, they will have capital gains of $240,000 and no exemptions. Accordingly, they will each pay capital gains on $120,000. At a rate of 20%, they will each owe about $24,000.
Is There a Way To Avoid Capital Gains Taxes?
So can you have your cake and eat it too? Yes! By transferring your primary residence to a properly drafted irrevocable grantor trust. You remove the home from your ownership and control. Thereby beginning the 5-year look-back, while retaining the primary residence capital gains exemption.
Joan Reed Wilson Esq. – Managing Partner
Practices in the areas of estate planning, elder law, Medicaid planning, conservatorships, probate and trust administration, and real estate. Admitted to practice in the States of Connecticut and California, she is the President of the CT Chapter of the National Academy of Elder Law Attorneys (NAELA), an active member of the Elder Law Section of the Connecticut Bar Association, accredited with the PLAN of CT for Pooled Trusts, with the Veteran’s Administration to assist clients with obtaining Aid & Attendance benefits for long-term care needs and with the Agency on Aging’s CareLink Network.