Ask Liz Weston

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Taxes

Q&A: Selling a rental property? Here are the tax consequences

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Dear Liz: My siblings and I are considering selling a triplex. It was bequeathed to us by our mother when she died in 2007. There is no mortgage and it is fully occupied. If we sell, my wife and I (both over 50) would get roughly $200,000, and we’d like to minimize the tax impact. We own our home free and clear and have no debt. We’d like to use this windfall to help our son buy a home. We’d also give our daughter a cash gift. We have no interest in buying another investment property using a 1031 exchange. Any suggestions to minimize our tax bill given our circumstances?

Answer: Talk to a tax pro, because selling a rental property is more complicated than selling your personal home.

You’re not eligible for the $250,000-per-person home sale profit exclusion, and in addition to paying capital gains tax you also face a depreciation recapture tax of 25%. (Depreciation is the amount of wear-and-tear you wrote off during your ownership of the property; the IRS requires you to repay that tax break when you sell.)

A big capital gain could affect other areas of your finances, such as Medicare premiums, and the pro can help you plan for that as well.

A 1031 exchange would allow you to defer taxes on a rental property by buying a similar replacement property.

Another solution would be to hang on to the property, continue to enjoy the rental income and bequeath your portion of it to your children when you die. Your portion will receive a favorable step-up in tax basis so that your heirs won’t owe taxes on the capital gains that occurred during your ownership. They also won’t face the tax on depreciation recapture you would otherwise owe.

But that obviously isn’t a good solution if you no longer want to be a landlord or want the cash instead. In that case, the tax pro can help you properly account for selling costs, legal fees and improvement expenses that could reduce the tax hit and may be able to suggest other ways to manage your tax bill.

Q&A: Taxes on a deceased spouse’s assets

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Dear Liz: My dear friend’s husband just passed away and she is immediately selling off all his antiques through an auctioneer. Sales should net well over $100,000 this calendar year. Is there any way to offset the tax hit she will take on this? This will be on top of selling the house in the same calendar year.

Answer: Previous columns have discussed the favorable “step up” in tax basis that happens when someone dies.

Their assets, including at least half of a jointly-owned home, typically get updated to the current market value for tax purposes. Appreciation that occurred during the deceased’s lifetime is never taxed. In community property states, both halves of jointly-owned assets usually get this step up.

The auction shouldn’t generate much if any tax bill unless the antiques jump significantly in value between the date of his death and the date of the sale.

The same is true of the home sale if the friend lives in a community property state. If not, she may have potentially taxable appreciation on her half of the property. If the sale occurs within two years after the year her husband died, though, she can exclude up to $500,000 of home sale profits from her income. Otherwise she can exclude up to $250,000.

Your friend should consult a qualified tax pro who can review her specific situation and offer individualized advice.

Q&A: Surviving spouse’s home gains

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Dear Liz: If a surviving spouse is selling the couple’s longtime home, are there any special provisions on the long-term capital gains?

Answer: When one spouse dies, their half of the home gets a new value for tax purposes. The value is “stepped up” to the current market value, so that the appreciation that happened on that half of the property is no longer taxable. In community property states, both halves of the property get this step up.

Let’s say a couple bought a home for $100,000 and that it was worth $250,000 when the first spouse died. In most states, the tax basis — what’s subtracted from the net sales price to determine potentially taxable capital gains — would rise from the original $100,000 to $175,000. The surviving spouse’s basis would remain at $50,000 while the deceased’s half would be stepped up to $125,000 (one half of the current $250,000 value). If the home was sold for $250,000, there would be $75,000 of potentially taxable capital gain.

In community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin — the home’s basis would get a double step-up to $250,000. If the home was sold for $250,000, there would be no potentially taxable capital gain.

Even if there is a gain from the sale, a single person can exclude up to $250,000 of home sale capital gains from their income as long as they owned and lived in the home at least two of the previous five years. Couples can exclude up to $500,000. However, widows and widowers who sell their homes within two years of their spouse’s death can take the full $500,000 exclusion.

Q&A: A gift for the great-grandkids? Consider a 529 college savings plan

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Dear Liz: Recently my granddaughter gave birth to twins. I’d like to put $500 into a trust for each of them to mature when they are 18. I’m hesitant to set up an education fund in case they decide not to go on to college. I would like something that includes growth and safety, the least amount of cost and minimal tax consequences. Is there something you could recommend?

Answer: A trust would be overkill, given the relatively modest amount you have to contribute. Consider instead setting up 529 college savings plans, which provide the benefits you’re seeking, including some flexibility in how the money is spent.

The money you contribute can be invested to grow tax-deferred. Withdrawals are tax-free when used for qualified education expenses, which include costs at vocational and technical schools as well as colleges and universities. In addition, up to $10,000 per year can be used for private school tuition for kindergarten through 12th grade. If a beneficiary doesn’t use the money in their account, the balance can be transferred to another close relative. The account owner (you) also can withdraw the money at any time. You would pay taxes on any earnings plus a relatively modest 10% penalty.

Legislation passed at the end of last year offers another option: Money that’s not needed for education can be transferred to a Roth IRA, starting in 2024. After an account has been open at least 15 years, the beneficiary can start rolling money into a Roth. The amount rolled over can’t exceed the annual contribution limit (which in 2023 is $6,500), and the lifetime limit for rollovers is $35,000.

These plans are offered by the states and operated by various investment companies. You can learn more at the College Savings Plan Network.

Q&A: Estate taxes on house bequests

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Dear Liz: You recently wrote about the capital gains tax implications when someone sells a house they’ve been given, versus one they’ve inherited. Would you elaborate on the estate ramifications for the donor if that person has a large estate? Would their estate pay tax on the gift?

Answer: Few people have to worry about either gift or estate taxes, for reasons that will become obvious in a moment. But large gifts can potentially reduce the amount a wealthy donor can pass on to heirs tax free after death.

That’s because the gift and estate tax systems are combined. Gifts over the annual exclusion amount — which in 2023 is $17,000 per recipient — reduce the donor’s lifetime gift and estate tax exemption, which in 2023 is $12,920,000.

Let’s say a donor gives a $1-million house to a friend. The amount in excess of the $17,000 annual limit, or $983,000, is deducted from the donor’s lifetime limit. If the donor died in 2023, the amount of their estate in excess of $11,937,00 would be subject to estate taxes. (Donors only owe gift taxes after they give away so much that they exhaust that lifetime limit.)

Receiving assets as a gift also means the recipient may face more taxes than if they had inherited the property.

The previous column mentioned that when someone inherits a home, the house’s tax basis is “stepped up” to the current market value. That means the appreciation that occurred during the previous owner’s lifetime isn’t subject to tax.

If someone is given a house by a still-living donor, different rules apply. There’s no step up in value. The recipient gets the donor’s tax basis, which is typically what the donor paid for the home, plus any qualifying improvements.

When the house is sold, that basis is deducted from the proceeds to determine potentially taxable profit. The recipient could face capital gains taxes on the appreciation that happened since the original owner bought the house.

On the other hand, giving away assets during life is one way to control the size of a potentially taxable estate, says Los Angeles estate planning attorney Burton Mitchell. Once the house is given away, for example, its future appreciation won’t increase the donor’s estate.

Anyone with an estate large enough to worry about these taxes should, of course, consult an estate planning attorney about the best strategies for their situation.

Q&A: Recourse when the IRS goofs

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Dear Liz: Is there a “court of last resort” when dealing with the IRS and the Treasury Department? I tried to buy an I bond using my tax refund. My tax preparer checked the appropriate box on the 1040 and submitted the form 8888. No bond was sent to me and I have been sent back and forth between the Treasury and the IRS multiple times. Finally the IRS admitted it did not notify the Treasury like it should have to generate the bond and it did apologize.

The Treasury says it can’t issue the bond without the notification from the IRS, and the IRS claims there is nothing it can do to fix the problem now. Is there any recourse whereby I can get my bond? I followed all of the rules, the 1040 was correct and to tell you the truth, I am unhappy that there does not seem to be a way of righting a wrong not of my making.

Answer: Start by contacting the Taxpayer Advocate Service, which was created in part to help resolve problems like this. You’ll find it at taxpayeradvocate.irs.gov.

Also consider reaching out to your congressional representatives, who have constituent services that may be able to help.