Q&A: Capital gains taxes explained

Dear Liz: Do I understand correctly that I must live in a house for two years before selling it to avoid paying capital gains tax, regardless of how much I may profit from the sale?

Answer: You do not. You must live in a home for two of the previous five years to exempt up to $250,000 of home sale profits. (Married couples can exempt up to $500,000.) After that, you’ll pay capital gains taxes on any remaining profit.

Even if you didn’t last the full two years, you may be able to claim a partial exemption if you meet certain criteria, such as having a change in employment, a health condition or other “unforeseen circumstance” that required you to move out.

Q&A: Capital gains tax on home sale profit

Dear Liz: I recently sold a home and am trying to escape the dreaded capital gains tax. I’ve done everything I can to reduce my overall tax bill, including maxing out my retirement contributions. I don’t want to buy a more expensive home to escape the gains tax. Any thoughts?

Answer: Buying a more expensive home wouldn’t change what you owe on your previous home. The days when you could roll gains from one home purchase into another are long gone.

These days you’re allowed to exclude up to $250,000 in home sale profit from your income (the limit is per person, so a couple can shelter $500,000). In other words, that amount is tax free, as long as you lived in the home for at least two of the previous five years. Beyond that your profit is subject to capital gains taxes. The top federal capital gains rate is 20%, plus a 3.8% investment surtax if your income is more than $200,000 for singles or $250,000 for married couples.

Here’s where good record-keeping may help. While generally you’re not allowed to deduct repair and maintenance costs from that profit, you can use home improvement expenditures to reduce the tax you owe. Home improvements are added to your cost basis — essentially what you paid for the property, including settlement fees and closing costs, and that’s what is deducted from your net sales price to determine your profit.

You’ll need receipts plus credit card or bank statements to prove what you paid. Improvements must “add to the value of your home, prolong its useful life, or adapt it to new uses,” according to IRS Publication 523, Selling Your Home. Examples of improvements include additions, remodels, landscaping and new systems, such as new heating or air conditioning systems. You can include repairs that are part of a larger remodeling job, but you can’t include improvements you later take out (such as the cost of a first kitchen remodel after you do a second one).

4 tax hacks you might not know

You know to contribute enough to your 401(k) to get the full company match. Maybe you’ve even adjusted your withholding so you’re not giving Uncle Sam an interest-free loan.

Yet you may feel the need to do even more, especially if you’re making the last big push toward retirement. These hacks allow you to shelter more money from taxes now and when you retire. In my latest for the Associated Press, the 4 crucial tax hacks you might not know.

Q&A: Credits can boost a refund beyond the taxes paid — and keep millions out of poverty

Dear Liz: A friend of mine received a 2016 tax refund of over $9,000 even though this person did not pay nearly that amount in taxes over the course of the year. My friend has a fairly low-paying job with no benefits, is a single parent of two young children and receives no support from the children’s other parent. Given this scenario, is it possible to get a tax refund in an amount greater than what you paid in taxes?

Answer: Absolutely, and these refundable credits keep millions of working Americans out of poverty each year.

Refundable credits are tax breaks that don’t just offset taxes you owe but also can give you additional money back. Most of your friend’s refund probably came from the earned income tax credit, which was initially created in the 1970s to help low-income workers offset Social Security taxes and rising food costs due to inflation.

The credit was expanded during President Reagan’s administration as a way to make work more attractive than welfare. Each administration since has increased the credit, which has broad bipartisan support.

The maximum credit in 2016 was $506 for a childless worker and $6,269 for earners with three or more children. Your friend probably also received child tax credits of up to $1,000 per child. This credit, meant to offset the costs of raising children, is also at least partially refundable when people work and earn more than $3,000.

Q&A: The give and take of federal gift tax rules

Dear Liz: We are planning to build an addition to our home so that my mom can move in with us and will take out a loan to pay for it. Let’s say that we put down $50,000 and take out a loan for the remaining cost of $150,000. After the addition is built, my mom will sell her house and with the proceeds she will give us $200,000 to pay for the cost of the addition. Is this considered a gift? Or is it considered payment for a place to live (i.e. she gets something in return), and therefore it is not a gift?

Answer: What do you want it to be?

If you want it to be a gift, then it certainly can be. If your mother wanted to give you the money all at once, she would need to file a gift tax return because the amount exceeds the $14,000 per recipient annual exclusion. But she wouldn’t need to pay gift tax until the amount she gives away in excess of the annual exclusion reaches a certain limit (which is $5.49 million in 2017).

Gifts in excess of the annual exclusion also affect how much of a wealthy person’s estate can pass tax-free to heirs. If your mother is worth more than about $5 million, she should consult an estate planning attorney before making any gifts.

If she doesn’t want to bother with a gift tax return, she could give you and your spouse $14,000 each, or $28,000, per year until she’s given the $200,000.

If you or your mother prefer to make payments over time and treat the money as rent, you would need to declare the income. You could write off certain rent-related expenses, such as a portion of insurance premiums and repairs, that wouldn’t be deductible otherwise, plus you’d get another tax break from depreciating the portion of the property that’s considered a rental.

But that could trigger a big tax bill when you sell the home, so make sure you run this plan past a tax pro who can help you weigh the costs and benefits.

Q&A: Avoiding estate taxes

Dear Liz: You recently answered a question about what a wealthy couple could do to reduce future estate taxes, and you mentioned the annual exclusion. They also could pay education and medical expenses for anyone, and there’s no annual limit.

Answer: Absolutely — and the couple’s estate planning attorney almost certainly would have informed them of this option.

The original letter came from one of the couple’s children, asking what their parents could do to reduce future estate taxes, in addition to the irrevocable trust that already had been set up. The reader lamented that the estate was bigger than the current exemption limits (now $10.98 million for a married couple) and so could incur estate taxes.

My answer was that the couple’s attorney would have told them of other options. One of those options is to use the annual exclusion of $14,000 per recipient to gift tens if not hundreds of thousands of dollars out of their estate. If the couple chooses not to use available options, and instead lets the estate incur the taxes, there’s not much the heirs can do about it.

Q&A: Federal estate tax exemption

Dear Liz: You mentioned that the federal estate tax exemption limit this year is $5.49 million per person. Can I double that if married?

Answer: Essentially, yes. Married couples can double the amount that can be given or bequeathed to heirs tax free. If one spouse doesn’t use up his or her exemption, the surviving spouse can use the remaining amount in addition to the surviving spouse’s own exemption.

You also should know that you can leave an unlimited amount of money to a spouse who is a U.S. citizen. (The rules for non-citizen spouses are different and could fill a whole column on their own.) This is known as the unlimited marital deduction.

Q&A: These heirs worry their parents aren’t doing enough to minimize estate taxes

Dear Liz: My parents, ages 75 and 76, have established an irrevocable gift trust for my five siblings and me. Wonderful! With the single trust, they have maxed out their lifetime gifting exemption. What else can they do with their other investments to minimize the inevitable estate taxes that will come with their deaths? They have lived a frugal life of caution and reserve, but before their nest egg can be distributed to their heirs, the government will extract millions of dollars.

Answer: If your parents maxed out their lifetime gift exemption, that means they contributed more than $10 million to the trust. It also probably means they employed an estate-planning attorney, since such trusts aren’t typically do-it-yourself projects. If that’s the case, the attorney probably has reviewed with them their other options for minimizing taxes.

They could, for example, give each sibling $28,000 ($14,000 from each parent) each year — and make similar gifts to each sibling’s spouse and children, if they were so inclined. This annual exemption limit is separate from the lifetime gifting exemption they’ve already used. If each of you is married with two kids, that would move $672,000 out of their combined estates each year.

Another way to move money out of their taxable estate, either now or at their deaths, is to donate to charities.

If they opt not to take further steps, you can take comfort in the fact that the top estate tax rate is 40%, which means the bulk of their estate will still reach their heirs. Also keep in mind that you’re in rare company — only about two estates out of 1,000 are large enough to trigger an estate tax return, now that exemption limits have been raised to $5.49 million a person.

Q&A: Your gift won’t get you a medical deduction

Dear Liz: A couple I’ve known for years recently adopted 2-year-old twins. Both will need considerable medical care, as they were born to a drug-addicted mother. In sending out announcements, my friends suggested sending funds for the twins’ medical needs, rather than toys. I took note and sent a check earmarked for their healthcare. My question is: Can I include the gift in my own medical deduction for this year’s income taxes?

Answer: No. Only medical expenses paid for yourself, your spouse and your dependents typically qualify for the medical expense deduction on your income tax returns.

The expense isn’t a charitable deduction either. Contributions have to be made to qualified charities to be deductible, and individuals don’t qualify.

Q&A: Claiming an adult child as a dependent

Dear Liz: I am paying rent for my adult son in another state. He gets occasional help from various services, but if I don’t want him to sleep on the street, I have to pay his rent and send some emergency food. I don’t see this changing. Can I claim him as a dependent or would that make me responsible for his health insurance, which I cannot afford?

Answer: Yes, you would be responsible for your son’s health insurance coverage if you claimed him as a dependent, said Carolyn McClanahan, a certified financial planner with Life Planning Partners in Jacksonville, Fla. That would mean either paying for coverage or paying the fine for not having coverage. The fine for 2016 is $695 per adult or 2.5% of your household adjusted gross income, whichever is greater. The penalty is capped at $2,085, which is likely much more than what you’d save with an additional exemption. If you’re in the 25% tax bracket, a $4,050 personal exemption is worth a little over $1,000.

The IRS has many rules about dependents, and standards for claiming adult children are much higher when they’re over 19 (or over 24 for full-time students). To qualify, your son would have to earn less than the amount of the personal exemption ($4,050 in 2016) and you must have provided more than half of his support, among other rules. The IRS has an interactive tool to help people determine dependents’ eligibility at https://www.irs.gov/uac/who-can-i-claim-as-a-dependent.