Ask Liz Weston

Get smart with your money

capital gains

Q&A: What’s the most tax efficient way to donate your RMD?

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Dear Liz: My wife and I are in our 70s and receive required minimum distributions from IRAs. We make our charitable contributions out of our RMDs. We have considered a donor advised fund. Which vehicle provides the best tax savings?

Answer: You would typically get the most tax benefit from qualified charitable distributions, which allow people 70½ and older to contribute money to charities directly from their IRAs. QCDs can satisfy required minimum distributions without increasing your adjusted gross income. That, in turn, can mean less taxation of your Social Security benefits and may help you avoid or reduce income-related surcharges on your Medicare premiums.

QCDs must go directly from your IRA custodian to the charity. A check issued by the custodian and payable to the charity can qualify even if you deliver it. It’s not a QCD if you receive the distribution and then pay the charity yourself.

Donor-advised funds work differently. You contribute cash or securities to the fund and may qualify for a tax deduction if you itemize. The contributions can grow tax-free until you direct the fund to make grants to eligible charities, potentially years later.

You can’t make QCDs to donor-advised funds, but these can be useful if you want to make several years’ worth of charitable contributions at once or donate appreciated securities. Donating those investments rather than selling them can avoid capital gains taxes.

For annual charitable giving from your IRAs, however, QCDs are likely the better choice. Talk to your tax pro about how to make sure your donations meet the QCD rules.

Q&A: Can you tap your equity without triggering capital gains?

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Dear Liz: I know from personal experience after selling a longtime residence that tax return information is shared with the Social Security Administration. If the two-year look-back shows high enough modified adjusted gross income, Medicare premiums can increase significantly. There are appeal options, but a one-time home sale doesn’t necessarily qualify.

Should the couple consider a home equity line of credit to generate funds without triggering taxes?

Answer: That’s one option a financial planner might suggest, although HELOCs typically have variable interest rates and require monthly payments, which can burden retirees.

Another possibility is a reverse mortgage, which generally costs more but doesn’t require monthly loan payments. Interest and fees increase the loan balance, reducing equity available for future needs. Borrowers must continue paying property taxes, insurance and maintenance, and the loan generally comes due when they sell or permanently leave the home.

But again, taxes are just one factor. The planner can help them sort through all their options to find one that best fits their goals and needs.

Q&A: Why selling a valuable home can cost more than you think

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Dear Liz: Why do you seem to discourage older people living in homes that have appreciated over the years from selling because of the tax consequence? Recently, someone complained they could not move out of their family home because they would owe $400,000 in taxes. Why don’t you show the math: If they owe $400,000, even at the maximum (20% capital gains), that means they received $2,000,000. So even after taxes, they net $1,600,000. People who are asking the question you answered today need to either recognize they are swimming in money after taxes, or that they incorrectly think their net profit is taxed 100%.

Answer: If you’re referring to the couple who wanted to use their home sale proceeds to give down payments to their children, your math is a bit wonky.

The couple said selling their paid-off home would generate more than $1 million in proceeds. Proceeds aren’t the same as taxable gains, and the tax bill depends on the home’s original cost, qualifying improvements, selling expenses and the $500,000 home-sale exclusion for eligible married couples.

Taxable home sale gains can have the same impact as Roth conversions, in that they can raise Medicare premiums, make more Social Security benefits taxable and push other income into higher tax brackets. Some taxpayers also face the 3.8% net investment income tax.

Furthermore, the couple weren’t complaining that they couldn’t sell their home — they wanted to. My response was to remind them that their generosity could have big financial consequences.

Your ultimate point is a good one, though. Taxes matter, but they should never be the only consideration in a major financial decision.

Q&A: Should you give your kids their inheritance early?

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Dear Liz: My wife and I are 68 and 69, respectively, have been retired for more than a decade, and enjoy a comfortable retirement income from my pension and her Social Security (I’ll take mine at 70). We have no mortgage and enjoy steady growth in our retirement savings, which we rarely touch.

Both of our children have good, steady jobs but may never own homes here in California owing to extraordinarily high prices. My wife and I own our home outright and could generate north of $1 million in proceeds from its sale. Our children will inherit all of our assets, including the home, when we die, but we’re wondering “why wait?” Why not help them purchase homes now by selling ours and splitting the proceeds between them for meaningful down payments? We’re happy to rent if it means they can enjoy the benefits of home ownership now rather than later when homes will surely be even more expensive. Good idea or bad idea?

Answer: This could be a lovely idea or a disaster, depending on your circumstances and what the future may hold. If you or your wife need long-term care in the future, for example, you may regret cashing out this valuable asset.

Renting carries risks, as well. You could face potentially rising costs each year even in areas with rent control.

Also consider that selling your house could generate a significant tax bill. Your gain is generally the sale price minus what you paid for the home, certain selling costs and the cost of qualifying improvements you’ve made over the years.

You and your wife can exclude up to $500,000 of the gain, but the remainder likely would be taxable. The federal capital gains tax rate is usually 15% but can be up to 20% for those with high incomes. California doesn’t have a separate capital gains rate so you’d face an income tax rate of up to 13.3%.

If your children inherit the house instead, its tax basis generally would be adjusted to its value at your death, eliminating capital gains taxes on appreciation during your ownership. Of course, that could mean they’d have to wait decades for their inheritance, which would defeat your expressed goal of helping them buy homes now.

You may not have to give up homeownership yourself to make it possible for your children. Downsizing could help you free up cash for significant gifts, for example. (Gifts of this size generally require filing gift-tax returns, although you likely wouldn’t owe gift tax. The federal lifetime estate and gift tax exemption is currently $15 million per person.)

A fiduciary financial advisor could help you determine how much you can safely afford to give away without jeopardizing your own future. A tax professional or estate-planning attorney can help you structure any gifts in a tax-efficient way.

Q&A: Living in your rental? The tax benefits aren’t so clear cut

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Dear Liz: My husband and I have owned a rental property for 20 years. We’ve never lived in it. Now, we want to get out of the landlord business. We know we’ll have to recapture depreciation, but we always thought we could live in the property for a couple of years to save some on the capital gains taxes. Our accountant has told us that this is no longer true and we cannot save much by living in our rental. Federal and state taxes will take most of our profit. Is this true?

Answer: Congress dramatically shrank the loophole that once allowed people to reduce or eliminate capital gains on rental and vacation properties.

When selling a primary residence, homeowners can shelter up to $250,000 of home sale proceeds, or $500,000 for married couples, from capital gains tax if they’ve owned and lived in the home at least two of the previous five years. Those rules were established in the Taxpayer Relief Act of 1997.

Before the Housing Assistance Tax Act of 2008, landlords could move into their rentals for a couple of years, sell the properties and then invoke the home sale exclusion as if the property had been their primary residence all along.

Today most if not all of the gain on your property is considered “non-qualified use.” Only the appreciation you experienced before 2009, and after you move in, would qualify for the exemption.

The benefits of moving into a rental for a couple of years can vary greatly, depending on the specifics of your situation. Your tax pro can walk you through the math and advise you about some of your other tax-saving options, such as a 1031 exchange for another rental property or holding the real estate until death, when your heirs would benefit from a valuable step-up in basis. If you’re done with being a landlord, though, the cleanest solution might be to simply sell and pay the tax.

Q&A: How are IRA withdrawals taxed?

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Dear Liz: I’m aware that assets held in tax-advantaged accounts, such as an IRA or 401(k), avoid capital gains taxes on the sale of an asset. However, will those capital gains taxes have to be paid later when it is time to withdraw money from those accounts? If yes, can I offset it with any capital losses?

Answer: Traditional retirement accounts such as IRAs or 401(k)s change how investment gains are taxed. You don’t pay tax when investments within the accounts are sold, but withdrawals from the account are typically taxed as ordinary income, not as capital gains. So you won’t have an opportunity to directly offset capital gains with losses as you would with nonretirement accounts.

However, if your losses exceed your gains in your nonretirement accounts, you can use up to $3,000 of capital losses to offset ordinary income each year. Any remaining losses can be carried forward to the next year where it’s rinse and repeat: capital losses offset capital gains, with up to $3,000 of any remaining loss used to offset ordinary income. This goes on until the losses are finally used up.