Q&A: Here’s a big tax mistake you can easily avoid

Dear Liz: I’m self-employed and my wife wasn’t working last year. In December, we returned to California and found a small home to purchase using $107,000 I took out of my IRA. Since we weren’t quite certain of what our income would be, we received our health insurance in Oregon through an Affordable Care Act exchange.

When we filed our taxes we got hit with a $20,000 bill for the insurance, because we earned too much to qualify for subsidies, and a $10,000 bill for the IRA withdrawal. Our goal was to own our home outright, which we do, but now we have a $30,000 tax bill hanging over us.

Can we work with the IRS somehow on this? We didn’t “earn” the $107,000; we invested it in a home. It wasn’t income, so why should we be punished for using our savings to purchase a home?

Answer: If you mean, “Can I talk the IRS out of following the law?” then the answer is pretty clearly no. The IRA withdrawal was income. It doesn’t matter what you did with it.

Consider that you probably got a tax deduction when you contributed to the IRA, which means you didn’t pay income taxes on that money. The gains have been growing tax deferred, which means you didn’t pay tax on those, either.

Uncle Sam gave you those breaks to encourage you to save for retirement, but he wants to get paid eventually. That’s why IRAs and most other retirement accounts are subject to required minimum distributions and don’t get the step-up in tax basis that other investments typically get when the account owner dies.

(If you did not get a tax deduction on your contributions, by the way, then part of your withdrawal should have been tax-free. If you’d contributed to a Roth IRA, your contributions would not have been deductible but withdrawals in retirement would be tax-free.)

The IRS does offer long-term payment plans that may help. People who owe less than $50,000 can get up to six years to pay their balances off. You would file Form 9465 to request a payment plan. The IRS’ site has details.

Here’s a good rule to follow in the future: If you’re considering taking any money from a retirement account, talk to a tax professional first. People often dramatically underestimate the cost of tapping their 401(k)s and IRAs; a tax pro can set you straight.

Q&A: Figuring homes’ adjusted basis

Dear Liz: In your response to a question about the adjusted basis of a residence after the death of a spouse, you state that the surviving spouse may add to the adjusted basis “any commissions or fees paid to purchase the property and the cost of improvements.” Your example adds $150,000 in “improvements over the years” to the $850,000 value of the home at the time of the spouse’s death in 1992. Wouldn’t those improvements (and other costs) have to be made after the date of the spouse’s death, since otherwise they would already be included in determining the value of the home at the date of death?

Answer: Good point. If the surviving spouse lives in a community property state, only improvements that happened after the date of the first spouse’s death would increase the basis, because both halves of the property get a step up to the current fair market value when one spouse dies. In other states, only the deceased spouse’s half of the property would get the step up. The surviving spouse can add his or her half of the improvements made before the death, and anything done after the death, to the tax basis to determine home sale profits.

Q&A: Capital gains on house sale

Dear Liz: I am one of those seniors who purchased their house in the 1970s. I would like to move but I’m reluctant because of the huge capital gain tax that I would have to pay. The exemption amount has not been raised since 1997 when it was enacted. In comparison, the estate tax exemption has risen from $600,000 in 1997 to more than $11 million currently. Wouldn’t raising the capital gain exemption stimulate the real estate market as more people would put their homes on the market and give more first-time buyers a chance at homeownership?

Answer: Perhaps, but you shouldn’t let tax law be the sole determinant of what you do or don’t do. Minimizing taxes can be a factor in your decisions but shouldn’t be the only one.

Also, keep in mind that the median home price in the U.S. is currently $226,300, according to real estate site Zillow. Most homeowners haven’t seen and probably won’t see enough appreciation to use a single $250,000 exemption, let alone the $500,000 available to couples.

So you may have a problem, but it’s an enviable problem. Even if you pay taxes at top rates, you’ll still have a substantial sum left over. And you may be able to spread out the tax bill using an installment agreement, in which the buyer pays you over time. You’ll want a tax pro’s help if you go that route, but you should consult one in any case to make sure you’re taking advantage of every other legal opportunity to reduce what you owe.

Q&A: Loans, taxes and home sales

Dear Liz: You recently answered a question about determining home sale profits for a widow. My question is how you calculate taxes when there’s a loan in the mix. For instance, when I bought my home, I took out a mortgage. Subsequently, I took out a second mortgage to pay for a pool and landscaping. I also refinanced several times, but never took a mortgage with cash out. Please advise me how to calculate my cost basis given these loans. Of course, you can broaden your response to include other loan scenarios and how they play into cost basis.

Answer: This will be a short answer, because they don’t. What you owe the mortgage lender(s) is typically irrelevant for calculating your capital gain.

Q&A: Figuring home-sale taxes

Dear Liz: My husband and I bought a home in Los Angeles in 1976 for $200,000. He died in 1992. The value of the house was at that time about $850,000. (I had it appraised.)

I want to sell the house now. The value is about $2 million. How much would be the stepped-up base for capital gain tax when I sell it?

Answer: In most states, only your husband’s half of the home would have gotten a new tax basis at his death. (A tax basis is used to determine potentially taxable profit.) In community property states such as California, however, both halves of a property get the step up in basis when one spouse dies.

You can add to your basis any commissions or fees paid to purchase the property and the cost of any additions or improvements. What you spent on maintenance and repairs doesn’t count. The improvement must add to the value of your home, prolong its useful life or adapt it to new uses to qualify, according to the IRS.

To figure your taxable profit, you’ll take the net amount you receive from the sale — the sale price minus any commissions or fees paid to sell the home — and subtract your basis from that. You can exempt up to $250,000 of the home sale profit, but you would pay long-term capital gains rates on the rest.

Let’s say you invested $150,000 in improvements over the years. That would be added to your $850,000 basis for a total adjusted basis of $1 million. Let’s also assume you pay $100,000 in commissions to sell your home, netting $1.9 million. Your $1 million basis would be subtracted from the $1.9 million, leaving you with a $900,000 home sale profit. Because $250,000 of that would be exempt, you would owe long-term capital gains tax on $650,000.

Q&A: Avoiding capital gains

Dear Liz: In a few years, my husband and I will sell our large primary residence and move into a smaller home for our retirement. We are both over 55. We currently rent out the smaller home and pay a mortgage on it. We will realize a small capital gain on the large residence when it is sold. Rather than use our one-time exclusion for the sale of a primary residence, can we avoid capital gains by putting the small profit toward paying down the mortgage principal on the smaller home when it becomes our primary residence shortly after selling the large house?

Answer: The ability to defer capital gains taxes on home sales and the one-time exclusion for home sale profits were repealed in 1997. Before that, capital gains taxes were typically due on home sale profits unless the homeowners bought a house of equal or greater value within two years of the sale. The exception was for people 55 or older, who could exclude up to $125,000 of home sale profit from their incomes once in their lives.

Now, when you sell a home, regardless of your age, up to $250,000 in home sale profits can be excluded by an individual or $500,000 by a married couple. You can do this multiple times, as long as you live in each home at least two of the preceding five years.

There are some issues with converting a rental property into a primary residence, however, especially if you should want to sell it someday. You should discuss this with a tax professional.

Q&A: Cash is king when it comes to home improvements

Dear Liz: My husband and I are squabbling over how to pay for the pool we may get. We have a line of credit on the house, and rates are still low. I say we use that, make it part of the mortgage and pass the cost on to the next owner (assuming that, someday, we sell this house). He wants to pay cash, which seems insane to me. I don’t pay cash to buy a car — why wouldn’t I finance a pool?

Answer: You probably should pay cash for your cars. Borrowing money is usually advisable only when you’re buying something that can increase your wealth, such as an education that helps you make more money or a home that can appreciate in value. Paying interest to buy something that declines in value generally isn’t a great idea.

Whether a pool can add value to your home depends a lot on where you live. If pools aren’t common in your neighborhood, adding one may not add much if any value. A pool could even place you at a disadvantage by turning off potential buyers who might not want to deal with the hassle and expense of pool maintenance. Parents with young children also may shy away from pools because of the drowning risk.

Adding a pool could increase your home’s value if you live in a warm climate and most of your neighbors have pools. But even then, it’s unlikely that your pool will add as much value as it would cost to install. (Home improvements rarely result in a profit — even the best-considered upgrades typically cost more than the value they add.)

A reasonable compromise might be to finance half the cost and pay cash for the rest. You’ll still want to pay off the line of credit relatively quickly, though. Lines of credit typically have variable interest rates that can make this debt more expensive over time.

You won’t be passing on the cost to the next owner in any case. Any money you borrow against your home has to be paid off when you sell, reducing your net proceeds. That’s yet another reason not to borrow indiscriminately.

Q&A: Watch out for scams when trying to dump a timeshare

Dear Liz: How do I get out of a timeshare contract? A few years back, we signed up for one that’s associated with a major hotel chain. Promises were implied but not kept. Since then, I continually receive notices from legal groups that say all laws favor the timeshare developer and that my kids will take over my debt unless I pay the attorney thousands of dollars to get out of the contract.

Do you know of legitimate ways to sever the ties? I know I will lose my investment but would rather be out of the contract “for eternity.”

Answer: Timeshares typically include “in perpetuity” clauses meant to keep owners on the hook indefinitely for annual maintenance fees and other charges.

That doesn’t mean their heirs have to be on the hook, however. Your kids can “disclaim” — essentially, refuse to inherit — the timeshare on your death, as long as you haven’t put their names on the deed.

If you’re not happy with your timeshare, though, consider getting rid of it before your death. Check to see if the developer will take it back or if you can sell it on a site such as RedWeek or Timeshare Users Group. Don’t expect to get much, if any, money out of the deal. In fact, you may have to pay a year or two of maintenance fees in advance as a sweetener. That could be a relatively small price to get out of what otherwise might be a lifetime obligation.

It’s unfortunate that most timeshares don’t offer a simpler way out for owners. The difficulty in getting rid of timeshares opens the door for all kinds of scams and shady behavior, with companies charging thousands of dollars and often not delivering the exit they promise.

Q&A: Many factors go into rental choice

Dear Liz: You recently answered a reader who didn’t want to keep and rent out the home she inherited with her brother. You mentioned that if he refused to buy her out, she could go to court to force a sale.

Another option is to hire a property management company to provide a buffer between the siblings but also between them and the tenants. The house will provide a healthy income to both bro and sis.

Answer: Actually, we don’t know that. While Mom-and-Pop landlords can make a tidy profit with single-family homes in some areas, just breaking even is hard in others. In many high-cost areas of the country, rents aren’t enough to cover the considerable costs of ownership, especially if the property still has a mortgage.

Even if it’s paid off, the house could need extensive repairs or be damaged by future tenants. Vacancy rates could be high in that area, and the property management company would still need to get paid. The siblings also will need additional liability insurance to protect against being sued.

The sister could get a much better return from investments that require a lot less from her. Mutual funds don’t call to tell you the roof is leaking or the furnace needs replacement.

The home could turn out to be immensely profitable and still be a bad investment for a sister who’s an unwilling business partner and who resents the brother who refused to buy her out when he had the opportunity.

Q&A: Using your home’s equity to pay off credit card debt is a dumb move

Dear Liz: My ex-husband is a self-employed carpenter who just turned 64. He’s gotten a bit over his head with his credit cards. He tried for a home equity loan since he has plenty of equity and high credit scores. His mortgage lender says he doesn’t make enough money and that he needs a co-signer.

He owes only $50,000 on the house and needs about $40,000 to pay off his bills. Why should he be punished for working hard all these years? This is crazy and stupid. Is a reverse mortgage the way to go for him?

Answer: Possibly, but it’s concerning that he has so much credit card debt. Too often people who tap their home equity to pay off debt wind up worse off in a few years. They don’t fix the problem that caused the debt in the first place, so they continue to overspend — but now they have less of a home equity cushion to fall back on in case of emergency.

That’s especially true with a reverse mortgage. These loans allow people 62 and over to borrow against their home equity without having to make payments or repay the loan until they sell, move out or die. However, any amount they borrow and don’t repay will grow over time, typically at a variable interest rate. People who use reverse mortgages to pay off debt early in retirement can wind up unable to access their equity later, when they may need it more.

The lender isn’t trying to punish your ex for working hard, by the way. It’s saying he doesn’t appear to have enough income to pay his mortgage, cover the new loan payments and take care of his other bills. Your ex may think the lender’s standards are too strict, and it’s true many lenders are more reluctant to lend to the self-employed. He may find another lender that’s more cooperative if he shops around. But that huge amount of credit card debt indicates a serious problem that needs fixing, and another loan may not be the answer.

Since your ex feels comfortable sharing financial details with you, you might suggest that he discuss his situation with a credit counselor (the National Foundation for Credit Counseling offers referrals) and with a bankruptcy attorney (the National Assn. of Consumer Bankruptcy Attorneys). Each can assess his situation and offer different potential options he could consider.