Q&A: Death means capital gains take a holiday for heirs selling a house

Dear Liz: I am in my mid-80s and in declining health. I want to advise my beneficiaries about possible taxation on the sale of my home after I expire. I bought the place in 1995 for $152,000. It now has a market value of about $400,000. The issue is whether that gain is taxable upon the sale after my death. I also have a $57,000 long-term capital loss carry-forward in my income taxes, which is being written off at a rate of $3,000 each year.

Answer: The gain in your home’s value won’t be taxable at your death. Instead, the home will get what’s known as a “step up in basis.” That means its new value for tax purposes will be its market value when you die. So if it’s worth $400,000 when you die and your heirs sell it for $400,000, no capital gains taxes will be owed on the sale.

The news isn’t so good for your capital loss, however. Any unused carryover expires at your death and can’t be transferred to your estate.

As you know, capital losses — losses on investments or assets that you sell — can be used to offset capital gains and reduce your tax bill. If your losses exceed your gains, you can offset up to $3,000 of ordinary income each year. Any capital loss remaining after that can be used the next year in the same way: first to offset capital gains, then to offset up to $3,000 of ordinary income.

Often when taxpayers have such a loss, they’re encouraged to sell investments that have increased in value to help use up the loss faster, but you should talk to your tax pro and estate planning attorney to see if that makes sense in your case.

Q&A: Giving a gift with a built-in loss

Dear Liz: You recently answered a question about the tax implications of gifting stock to children. You mentioned that if the stock had lost value since its purchase, the children could use the loss to offset capital gains or, in the absence of gains, up to $3,000 a year of income, with the ability to carry over that loss to subsequent years until it’s used up.

But if a stock has a built-in loss, why not sell it, realize the loss and give the kids the cash? That way, the loss is sure to be recognized unless the donor dies before fully utilizing the capital loss or the carryover. If the child really wants that particular stock, he or she can use the cash to buy it. The children would have to be mindful of the wash-sale rules that prohibit deducting a loss if a related party buys the same stock, but waiting 31 days would be enough to avoid that.

In my view, there’s rarely a good reason to gift a stock (or most other assets) that has a built-in loss.

Answer: Exactly. Selling the asset and taking the tax benefit usually makes more sense than transferring the shares. The loss essentially evaporates, because the assets get a new value for tax purposes when transferred.

Selling losing stocks is certainly better than bequeathing them to your heirs. The loss essentially evaporates at your death, because the assets get a new value for tax purposes, so no one gets the potential tax break.

Q&A: Figuring out capital gains when an inherited house is sold

Dear Liz: I’ve have been following your responses related to the tax exemption on home sales. I understand that up to $250,000 per person of home sale profit is exempt from capital gains taxes and that married couples are entitled to exempt up to $500,000.

My spouse and her two siblings inherited a home from their parents. My father-in-law passed away four years ago, and my mother-in-law died last year. My wife was assigned as executor of their living trust. Who is entitled to take the tax exemption of the proceeds from the sale of the house? My wife? All three siblings? All of the above and their spouses?

Answer: None of the above, but don’t despair because the house will incur little if any capital gains when it’s sold.

We’ll assume your mother-in-law inherited the house outright from her husband, since that’s usually the case. When your mother-in-law died, the house received a “step up” in tax basis to reflect its current market value. If the house was worth $2 million when she died, for example, that’s the new value for tax purposes — even if she and your father-in-law paid only $25,000 decades ago for the house. All the gain that occurred in between their purchase and her death won’t be taxed.

If your wife sells the house for $2.2 million, there potentially would be some taxable capital gain. But the costs of marketing and selling the home would be deducted from its sale price. If those costs are 6% of the sale price — which is a pretty conservative assumption — the taxable gain would be about $68,000. (Six percent of $2.2 million is $132,000. Subtract the $2 million value at death and the $132,000 of sales costs, and you’re left with $68,000.) If your wife as executor sells the house and distributes the proceeds to the beneficiaries, the estate would pay the tax. If siblings inherit the house and then sell it, they would pay any tax.

Every year, millions of dollars of potential capital gain vanish this way as people inherit appreciated property. It’s a huge benefit of the estate tax system that many people don’t understand until they’re the beneficiaries of it.

Q&A: Capital gains

Dear Liz: If and when we sell our house, the capital gain is likely to exceed the $500,000 exemption limit. I am carrying over a loss of about $100,000 from stock sales. Can I use this loss to offset the capital gain from the house?

Answer: Yes. Capital losses can be used to offset capital gains, including those from a home sale.

Q&A: Spreading out the tax hit from capital gains

Dear Liz: We are in the lowest tax bracket. If we sell a capital gains asset worth several hundred thousand dollars, does that put us in a higher bracket and we pay 20% or do we remain in the lower bracket and pay 15%?

Answer: In the two lowest federal income tax brackets, the capital gains rate is actually zero. For a married couple filing jointly, taxable income below $18,550 in 2016 would put you in the 10% tax bracket, while income between $18,550 and $75,300 would put you in the 15% bracket. Both 10% and 15% income tax brackets pay no federal tax on long-term capital gains.

But capital gains count as income in determining your tax bracket. So a big capital gain can push you into a higher bracket, which means you would pay a higher capital gains rate.

Let’s say your normal taxable income is $75,000. You sell an asset with a $25,000 capital gain. Now you’re in the 25% tax bracket with taxable income between $75,300 and $151,900, which means your long-term capital gains rate will be 15%.

A really big gain would put you in the top 39.6% bracket, which applies to taxable income above $466,950. In that bracket, your capital gains rate would be 20%. Also, an additional 3.8% surtax applies for taxpayers with adjusted gross incomes over $250,000 for married couples and $200,000 for singles. The surtax is applied to the lesser of the taxpayer’s net investment income or the amounts over those limits.

There may be ways to alleviate or spread out the tax hit. You could sell losing investments to offset some or all of the gain. Another option for some assets is to sell a portion at a time over several years, or use an installment sale. A tax pro can walk you through your options.

Q&A: Calculating capital gains and losses

Dear Liz: With my father’s recent passing, I received a substantial inheritance, much of it in the form of stocks and mutual funds. If I sell these assets, do I calculate the capital gains and losses based on the date I took possession of the assets? Or do I use their value on the date of his death?

Answer: Typically you’d use the date of his death. If your father’s estate was very large and owed estate taxes, however, the executor may have chosen an alternative valuation date six months from the date of death. This option is available if the value of the estate would have been lower on the later date.

There is a circumstance in which your basis would be the value on the date the assets were turned over to you, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting U.S. If the executor elected the alternate valuation date, but the assets were actually distributed to you before that date, then the basis is the fair market value on the date of distribution, Luscombe said.

Inherited assets usually get a “step up” in basis when someone dies, so there’s no tax owed on any of the growth in those assets that occurred while the person was alive. Inheritors have to pay taxes only on the growth that occurs between the date of death (or the alternate evaluation or distribution date) and when the assets are sold.

The assets would get long-term capital gains treatment regardless of how long you’d owned them, which is another helpful tax break.

Q&A: Capital gains and mutual funds

Dear Liz: Your tax expert’s answer to a person who wanted to roll over a $30,000 capital gain on a mutual fund missed an important point. Since the couple were solidly in the 15% tax bracket with a taxable income under $72,000, they should qualify for the 0% federal capital gain tax rate. (They may, of course, owe state taxes.)

Answer: They may not have had a capital gain at all, as other tax pros have pointed out. When people own mutual funds, the earnings are often reinvested each year. If the couple paid taxes on those earnings, their basis in the mutual fund would increase each year. To know if the couple had any capital gain, we’d need to know that adjusted tax basis. In any case, the original answer — that you can’t roll over the gain on a mutual fund into another investment to avoid capital gains taxes — still stands.

Capital gains boost income tax bracket

Dear Liz: You recently wrote about potential capital gains on the sale of a property that was a gift from the parents (“Gifting home creates unnecessary tax bill“). The husband of the seller made $75,000 a year in income and the seller didn’t work. Isn’t it true that if his taxable income remains in the 15% bracket (taxable income of $70,700 or less), they would owe no capital gains tax, at least as it stands for 2012? With standard deductions, he would fall into the 15% bracket.

Answer: It’s true that the capital gains tax rate is zero for people in the 10% and 15% income tax brackets. But the amount of capital gains is added to your other income to determine your bracket.

“The $75,000 of current income plus $85,000 of gain would put them well into the 25% tax bracket and subject to the 15% capital gain rate,” said Mark Luscombe, principal analyst for tax research firm CCH. “A standard deduction of $11,900 plus a couple of exemptions of $3,800 each for 2012 could make part of the $85,000 gain taxed at a 0% rate, but the bulk of it would be taxed at the 15% capital gain rate.”

Gifting home creates unnecessary tax bill

Dear Liz: My wife and her brother are selling their parents’ home. The parents transferred the deed to their children’s names years ago. My wife should receive about $85,000 from the sale. Our yearly income (one salary; she’s a stay-at-home mom) is around $75,000. My wife is worried about capital gains taxes and wants to reinvest in another real estate property because she’s heard that that will eliminate the capital gains tax. Is that correct? I would really rather invest that money in our current home (finish the basement into a family room, update some items) and pay off our car loan than worry about another property to take care of. What do you think?

Answer: A 1031 exchange is a tax maneuver that allows owners of business or investment property to swap the real estate they have with another property, a transaction that can defer (but not necessarily eliminate) capital gains taxes.

It’s questionable whether your in-laws’ home would qualify as business or investment property, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.

“Were the parents paying rent to the children after the title was passed to the children? If the kids owned the property and the parents were living there without paying rent, I do not think that would constitute investment property,” Luscombe said. “Perhaps if the parents were still paying upkeep expenses and real estate taxes, that might approach the equivalence of rent.”

If there’s a chance the property might qualify, your wife should consult a tax pro experienced with 1031 exchanges for details. Otherwise, she’ll need to write some good-sized checks to the tax authorities. Currently the federal capital gains tax rate is a maximum of 15%, although it will rise to 20% on Jan. 1 if Congress doesn’t reach a compromise on the so-called fiscal cliff. Add to that any state or local taxes on capital gains.

You may think of these taxes as a small price to pay compared with the risk of owning a piece of rental property. Your wife may have another concern that she has not voiced, however: She may not want this legacy from her parents to disappear into the general family budget. She may feel an obligation to preserve and try to grow the money, rather than sinking it into home improvements and other consumption. Legally, gifts and inheritances are considered separate property owned only by the spouse to whom they were given, even in community property states where most other assets are considered jointly owned.

If she wants to keep this money separate, in other words, that’s her right. It would be nice if she carved out a small chunk for family consumption, but she’s under no obligation to do so. If a 1031 exchange isn’t possible or feasible, then she could consult a fee-only planner about other ways to invest the money for the future.

By the way, it needs to be said: This tax bill was avoidable. If your in-laws had, instead of gifting the property, waited and bequeathed it at their deaths, the home would have received a so-called step-up in tax basis. Such a step-up in effect eliminates the need to pay capital gains taxes on any home price appreciation that occurred during the parents’ lives. Any parent thinking of adding a child’s name to a real estate deed should first consult an estate planning attorney to understand the ramifications, since gifting property this way can be an expensive mistake.

Home sale tax break won’t disappear

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.