Real Estate Category
Dear Liz: You recently answered a question about capital gains taxes that stemmed from two siblings selling their parents’ home. The children had been added to the parents’ deed, presumably before the parents’ death. You mentioned that the capital gains tax would have been avoided if the parents had bequeathed the home rather than gifting it during their lifetimes. Presumably bequeathing the home at death would have necessitated probate and incurred inheritance taxes. Are these costs more than offset by the stepped-up tax basis received?
Answer: Your questions illustrate exactly why no parent should add a child (or anyone else) to a home deed without discussing the issue with an estate-planning attorney first. Too often, laypeople misunderstand what’s involved in probate and make expensive mistakes trying to avoid it.
In some states, probate — the court process that typically follows death — is relatively swift and not very expensive. Trying to avoid it isn’t necessarily cost effective. In other states, including California, the process potentially can take many months and eat up a good chunk of an estate. When that’s the case, it can be prudent to take steps during life to sidestep probate at death.
There are often better ways to do so, however, than adding someone to a deed. A living trust, for example, can be a good way to avoid probate and preserve the tax benefits of bequeathing, rather than gifting, assets. Living trusts can vary in cost, but a lawyer can typically set one up for $2,000 or $3,000. If you compare that with the $25,000 or more the siblings will pay in capital gains on a relatively modest home sale, you can see that the living trust probably is a better deal.
Now let’s turn to the issue of estate taxes. If the assets left by the deceased are substantial enough to incur estate taxes, they will do so whether or not the estate goes through probate. Avoiding probate, in other words, does not avoid estate taxes. Currently, only estates worth more than $5.12 million face federal estate taxes. That limit is scheduled to drop next year to $1 million, but will still affect relatively few estates.
Dear Liz: Your column on the tax issues that develop when parents deed their property to their children should help educate a lot of people. But sometimes this is done to reduce the parents’ assets so they will be eligible for Medicaid after the expiration of the look-back period. In this case, paying the capital gains tax is appropriate, because they are asking the state to pay potentially very large senior care bills.
Answer: Some would question whether it’s ever appropriate for seniors to deliberately impoverish themselves by transferring away assets in order to qualify for Medicaid, which pays long-term care expenses for the indigent. The “look back” period, in which states examine asset transfers before a Medicaid application, was established to discourage such maneuvers. Once again, it’s smart to get a legal opinion before transferring big assets. An elder-law attorney could weigh in on the pros and cons of Medicaid planning.
Dear Liz: My wife and I are trying to sell our home, which has been our primary residence for six years. I am very concerned about the $500,000 capital gains exclusion. As I understand it, the exclusion would mean we wouldn’t have to pay taxes on our home sale profit. But we are confused about this exemption being tied to the “Bush tax cuts” that could expire Dec. 31. If we sell our home after that, could we lose the exemption?
Answer: No. The law creating a capital gains exemption for home sales went into effect May 6, 1997. It’s not tied to the tax cuts approved during President George W. Bush’s tenure that are set to expire at the end of the year.
So people who live in a home for at least two of the previous five years will still be able to avoid paying capital gains on their first $250,000 of home sale profit (or $500,000 for a married couple).
Another tax you likely won’t have to pay is a new 3.8% levy on what’s called “net investment income.” Some emails circulating on the Internet falsely claim that the tax, which is scheduled to kick in Jan. 1, is a real estate sales tax. In reality, it’s a potential tax on home sale profits that exceed the capital gains exemption limit, as well as on other so-called unearned income, including investment and rental income.
If your home sale profit doesn’t exceed the capital gains exemption limit, you won’t owe the new tax. If your profit does exceed the limit, the excess amount would be added to your adjusted gross incomes to determine whether you’d have to pay it. The 3.8% tax would be levied only on people whose adjusted gross incomes are more than $200,000 for singles and $250,000 for married couples.
Dear Liz: My husband and I are wondering whether it is time to file for bankruptcy. We have about $20,000 in credit card debt, largely because of a home addition and remodeling project my husband began five years ago. It has been much more costly and time consuming than he anticipated and is not even close to being finished. That prevents us from being able to refinance, which would free up money to pay our debt.
A mortgage broker recently suggested we apply for a home equity line to get enough cash for materials and labor to finish this project. We pay our mortgage and two car loans on time and make at least minimum payments on the cards.
My husband’s health has been declining, making it very difficult for him to do physical work on this project, and one of our kids has had two surgeries in the last few years, so there have been a lot of medical bills as well. How should we proceed?
Answer: You’re having trouble managing the debt you already have, so it’s definitely risky take on more. On the other hand, if you have enough home equity to get a line of credit, that could be a path out of this mess.
First, though, make an appointment with an experienced bankruptcy attorney (you can get referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org). A credit card balance of $20,000 isn’t by itself insurmountable, depending on your income, but the fact that you’re not paying much more than the minimums on your cards is a huge red flag — as are those medical bills.
The lawyer can review your situation and let you know whether bankruptcy is even a reasonable option. Each state’s laws differ, so you need to consult an expert.
If you decide instead to take out the home equity line, make sure you hire a competent and well-recommended contractor to finish what your husband started. The last thing you need is for someone else to botch the job.
Dear Liz: You write about it not being a good idea in many cases to pay off your mortgage, but does it make sense to do so to reduce savings so that we can be in a better position to help our high school junior get financial aid for college in a year? We also have a 529 and some investments and are savers.
Answer: Your income matters far more to financial aid calculations than your savings, said Lynn O’Shaughnessy, author of “The College Solution: A Guide for Everyone Looking for the Right School at the Right Price (2nd Edition).” Another important factor is how many children you have in college at the same time. If you have a high income and only one child in college, you may not get much or any help, regardless of how your assets are arranged.
Many schools ignore home equity when figuring financial need, however, so it might be worth running some numbers. You can do that by using the net price calculators included on every college website. Pick the schools your junior might want to attend and run two scenarios on each calculator: one with your current financial situation and another in which you’ve paid off your mortgage with your savings.
Many parents are overly worried about how their savings will affect potential aid, O’Shaughnessy said. Parental assets, including 529 accounts, receive favorable treatment in financial aid formulas. Your retirement assets aren’t included in the federal formula at all, and your non-retirement assets are somewhat shielded as well thanks to an “asset protection allowance.” The older you are, the more of an asset protection allowance you get. The allowance will be somewhere around $45,000 for a married couple in their late 40s, the typical age for college parents. For those over 65, the allowance is $71,000. Beyond that, you’re typically asked to contribute less than 6% of eligible assets toward your offspring’s education each year.
Dear Liz: I’m not sure whether I should be aggressively paying off the balance of my student loans or saving that money for a down payment for an apartment. I graduated from law school with $150,000 in federal and private loans. Over the last few years I’ve paid off most of that, but I still have about $50,000 in federal loans with a rate fixed at 3.75%. I fully fund my 401(k) each year, have an emergency fund of five months’ bare-bones living expenses and another $35,000 in fairly conservative, mostly liquid investments. I plan to change jobs in the next six to nine months and will likely take somewhat of a pay cut. I am torn right now as to whether I should continue aggressively paying off my loans, since that is a guaranteed 3.75% return on that money, or put the surplus into my investment account, which may earn a better return but also has some risk of losing principal. This would be my down payment money; I live in New York, so I have another five years or so before I could consider buying, and I’m currently single, so changes in my relationship status could change this goal. It would be wonderful to be debt-free, but it would also be comforting to have a bigger balance in my bank account.
Answer: You’ve already done well by fully funding your retirement, paying off those private student loans and building an emergency fund. At this point, you can’t make a truly wrong decision about what to do with your money. What comes next depends on your comfort level.
Many financial planners would advise against paying off that low-rate student debt. If inflation returns, the rate you’re paying could seem incredibly cheap. Also, paying off student debt doesn’t really increase your financial flexibility. It’s not like a line of credit that you can pay down and tap again later. The money you send off to your student lender is gone for good.
On the other hand, you’re not likely to earn a whopping return on money that’s earmarked for a goal within the next five years. If you need money within 10 years, it shouldn’t be in the stock market; if your goal is five years out, most of it should be in shorter-term bonds and cash, such as an FDIC-insured savings account or certificates of deposit with varying maturities. You could decide the guaranteed 3.75% return of paying off the debt is better than the alternative.
Like so much of adult life, the choice is yours. Unlike so much of adult life, you really can’t go wrong whichever path you take.
Dear Liz: Is it possible for me to buy a home without having my wife on the mortgage? She lost her business because of the recession. I do not want to deal with her creditors.
Answer: You can apply for a mortgage based solely on your own income, credit scores and debt-to-income ratio, if those are sufficient to buy the house you want. Your wife’s income and credit does not have to be considered.
If you can’t swing the purchase without her income, though, you’ll both need to spend some time improving her credit scores. That might include adding her as an authorized user to your credit cards. Another option is to negotiate settlements with her creditors in return for their deleting the collection accounts from her credit reports. You’d want to be cautious in these negotiations, especially if the statute of limitations on the debts hasn’t expired and your wife could be sued. Consider visiting DebtCollectionAnswers.com for help in negotiating with creditors.
Dear Liz: I went through a divorce in the last year after being separated for two years. During our separation, we closed credit cards with high balances to make sure neither party would spend more on credit. We also had to short sell our home. So, as a single woman in her mid-30s, I have credit that’s somewhat shot for now. How many months should I expect the short sale to affect my credit scores? And was closing the credit card accounts good or bad for my credit?
Answer: Closing credit accounts can’t help your credit scores and may hurt them. In a divorce, however, it’s usually wise to close all joint accounts. Otherwise, your credit rating is in the hands of your ex-spouse, who could trash your scores by paying accounts late or maxing out credit lines.
In any case, the short sale probably had a much greater effect on your credit than the account closures. Short sales typically damage your credit as much as a foreclosure, according to the company that created the leading FICO credit score. Recovery times are measured in years, not months. If your scores weren’t that high to begin with — say 680 in the 300-to-850 FICO scale — it would take about three years for your numbers to return to their old levels. If your scores were high, say 780, it would take about seven years to restore them to their old peaks.
These recovery times assume you handle credit responsibly from now on. That means having and lightly using a credit card or two, making all payments on time and ensuring no account goes to collections.
Dear Liz: Should my retired wife (age 74) and I (age 78) refinance our home just to lower our monthly payment by $100? I’m considering going for a five-year fixed at 2.74% followed by a 25-year variable. Our outstanding loans amount to $200,000. The value of our home has decreased to $400,000. My wife is fearful of the 25-year variable.
Answer: As she should be. According to mortality tables, she’d have to live with it longer than you will.
You two are old enough to remember the double-digit inflation of the 1970s and the havoc that wreaked. If inflation like that (or anything close) were to return, your mortgage payment could quickly become unaffordable.
Economists are concerned that all the cash that’s been pumped into the economy to fight the downturn could spark inflation if growth resumes. Too much cash chasing too few goods is what traditionally has led to serious inflation.
In any case, lenders know that today’s record low interest rates won’t last. That’s why they’re so eager to push loans that will become variable at some point — so that the borrowers will be the ones to shoulder the interest rate risk.
Some borrowers can take that risk, but they tend to be younger folks whose incomes are also likely to rise if inflation returns. For people on fixed incomes, the math really doesn’t work.
Do yourself and your wife a favor. If your current loan has a fixed rate, stay with what you have. If it doesn’t, consider refinancing to one that does.