Ask Liz Weston

Get smart with your money

Taxes

Q&A: Capital gains taxes

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Dear Liz: My wife owns a house that was separate property before our marriage. She has since fallen ill and needs round-the-clock care. I am selling the house to support this and will net about $250,000 at close. Will we have to pay capital gains taxes, or can I claim a one-time exemption, based upon this not being community property?

Answer: If your wife lived in the property as her principal residence for at least two of the five years prior to the sale, the profit would qualify for the capital gains exemption of up to $250,000 per owner.

People who have to sell their principal homes before they meet the two-year residency requirement may qualify for a partial exclusion if the sale was triggered by special circumstances such as a change in health or employment or “unforeseen circumstances.” You’ll want to talk to a tax pro about whether your wife’s situation qualifies.

Even if the gain is taxable, she may not owe tax on the entire amount netted from the sale. When figuring home sale profit, her basis in the home — essentially, what she paid for it, plus any qualifying improvements — is subtracted from what she nets from the sale.

There’s another way to avoid paying taxes on home sale gains, and that’s to hold on to the property until your wife’s death. At that point, the home would get a “step up” in tax basis to the current market value. An inheritor who sold the home at that market value wouldn’t owe any tax, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting U.S.

Q&A: Filing joint tax return while not married

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Dear Liz: Is it possible to file a joint tax return if you are not married but have lived together for more than seven years? We’ve owned property together for nine years.

Answer: What matters to the IRS is how your state treats your arrangement. Most states don’t recognize common law marriages, in which two people live together but don’t have a marriage license. But a few do.

The states that currently recognize common law marriages under some circumstances include Colorado, Iowa, Kansas, Montana, New Hampshire, South Carolina, Texas and Utah, according to the National Conference of State Legislatures.

States that recognize common law marriages entered into prior to certain dates include Pennsylvania before Jan. 1, 2005; Ohio before Oct. 10, 1991; Indiana before Jan. 1, 1958; Georgia before Jan. 1, 1997; and Florida before Jan. 1, 1968, according to the NCSL.

Also, most states do recognize common law marriages from those states where they are recognized, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. In other words, if you move from a state where common law marriage is recognized to one where it isn’t, your union may still be considered a legal marriage.

Same-sex marriages are somewhat different, Luscombe said. The U.S. Treasury and the IRS have ruled that same-sex couples who were legally married in jurisdictions that recognize their marriage are considered married for tax purposes, even if the state where they currently live doesn’t recognize their union.

Confused yet? Talk to a local tax pro who can advise you about the status of your arrangement.

Q&A: Tax credit for Roth IRA contributions

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Dear Liz: You told a reader that “contributions to a Roth are never deductible.” This statement is a common misconception and is not correct. You can get a tax credit for Roth IRA contributions as long as you fall under the income limits and itemize on your taxes. The credit phases out at $30,000 for singles and $60,000 for married couples.

Answer: A credit is different from a deduction, but thank you for pointing out a tax benefit that many people don’t know exists.

This non-refundable credit, sometimes called a Saver’s Credit, can slice up to $1,000 per person off the tax bill of eligible taxpayers. The credit is available to people 18 and older who aren’t students or claimed as a dependent on someone else’s return. The lowest income taxpayers — those with adjusted gross incomes under $36,000 for marrieds filing jointly or $18,000 for singles in 2014 — can get a tax credit of 50% of up to $2,000 per person ($4,000 for married couples) contributed to retirement plans. Those plans can include traditional or Roth IRAs, 401(k)s or 403(b)s, 457(b)s and SIMPLE IRAs, among others. The credit drops to 20% and then 10% before phasing out. The average amount saved isn’t spectacular: The IRS said credits averaged $205 for joint filers in 2012 and $127 for single filers, but every bit helps.

One of the problems with this tax break, besides so few people knowing about it, is that many low-income people don’t owe income taxes, so they have nothing to offset with this credit. Another issue is that taxpayers need to file a 1040 or 1040A and use Form 8880 to claim it. Low-income taxpayers often use the 1040EZ form, which doesn’t allow them to claim the credit or alert them that it exists.

Q&A: Bonus taxing

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Dear Liz: You recently answered a question from someone who wondered whether to pay off tax debt or credit cards with a $10,000 bonus. You asked why the person planned to put only about half the bonus toward debt instead of all of it. I think I know the answer. A bonus is considered taxable income, so someone in a high tax bracket likely would net only about half of the gross amount.

Answer: That’s a good point. Many people fail to factor in the tax bite when they get a windfall or cash in a retirement plan. The more money you make, the more painful that bite can be.

Q&A: Taking a mortgage for the tax deduction

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Dear Liz: My wife and I are both 66 and in good health. Currently we have about $1.2 million in IRAs. We’re receiving about $80,000 a year from a pension and $110,000 in salary. We have been aggressive about reducing any lingering debt. So we think we are in good shape for me to retire within the next year or so. If we decide to stay in our home rather than move, we will need to make some significant repairs and improvements. We were thinking of taking out a $200,000 mortgage to pay off our last remaining debt ($50,000 on a home equity line of credit) and fund the renovations. This would give us a better tax deduction and not incur the high taxes we would pay by making an IRA withdrawal. Our grown children have expressed no interest in the home after we die, so it probably would be put up for sale at that time. Does this seem like a reasonable approach if we choose to go that route? Anything we haven’t considered?

Answer: Considering the tax implications of financial moves is smart, but you shouldn’t make decisions solely on that basis. You especially shouldn’t take on mortgage debt just for the tax deduction. The tax benefit is limited to your bracket, so for every dollar in mortgage interest you pay you would get at best a federal tax benefit worth 39.6 cents. State income tax deductions might boost that amount, but you’d still be paying out more than you get back in tax benefits. You also would be locking yourself into debt payments at a time in life when most people prefer the flexibility of being debt-free.

If you’re comfortable having a mortgage in retirement, though, you might want to consider a reverse mortgage. Although once considered expensive loans of last resort for people who were running out of money in retirement, changes in the federal reverse mortgage program caused financial planners to reassess the no-payment loans as a potential wealth management tool. The idea is that homeowners could tap the reverse mortgage for funds, especially in bad markets, instead of depleting their retirement accounts.
Reverse mortgages are complex, though. The upfront and ongoing costs can be significant. Because you don’t make payments on the money you borrow, your debt grows over time and reduces the amount your heirs might get once the home is sold. You’d be smart to find a savvy, fee-only financial advisor to assess your situation and walk you through your options.

Q&A: The tax implications of downsizing

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Dear Liz: My mother just turned 75 and wants to downsize from her four-bedroom house. My father passed away six years ago. She owns her home outright, and at the time of my father’s death the value of the house was estimated at $1.2 million. Right now she has enough income from retirement accounts and investments to live comfortably. She could even buy another smaller property if need be. As the executor of her estate, I’m trying to help her decide what to do with the house. She could let another family member live in it who couldn’t pay rent but could help with upkeep; she could rent it out for market value; or she could sell. We see advantages and disadvantages with all three options. What do you think?

Answer: If she hasn’t already, your mother needs to hire a good estate-planning attorney who can help her evaluate her options. Consulting a fee-only financial planner and a tax pro may be a good idea, as well.

If she sells, your mother could face a sizable capital gains tax depending on where she lives. Federal law allows a certain amount of capital gains on the sale of a primary residence — $250,000 per person — to be excluded from income, but after that, capital gains taxes apply.

The gain would be the difference between the home sale proceeds and your mother’s tax basis in the home. At least half of the home received a “step up” in basis to the then-current market value when your father died. If your mom lives in a community property state, such as California, both halves of the property would have received this step up at his death. Any increase in value since then would be subject to capital gains tax (minus, again, the $250,000 federal exclusion).

There’s another tax issue to consider. If she dies owning this house, her heirs would get a tax basis equal to the property’s value at her death. In other words, regardless of the state where she lives, none of the house’s appreciation during her lifetime would be taxable.

The tax issues alone shouldn’t dictate what your mother does. But she should be aware of them to make an informed decision about what to do next.