Ask Liz Weston

Get smart with your money

capital gains

Q&A: Advisor may have overlooked tax bill alternatives

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Dear Readers: The following comment was prompted by my response to the letter from a couple in their 70s asking if they had made a mistake moving their $2-million portfolio, including $340,000 in a taxable account, to a new advisor. The advisor recommended investment sales that resulted in a $50,000 capital gain tax bill, and their accountant disapproved. I wrote that the tax pro might not be in the best position to judge whether the sales were necessary, since accountants are typically focused on reducing tax bills but sometimes diversification is necessary to avoid even bigger financial consequences down the road. Here’s another perspective.

Dear Liz: The comment that the accountant is not in the best position to evaluate is correct, as the accountant is only looking at the taxes. However, as a retired portfolio manager and chartered financial analyst, I really doubt that it was appropriate for the investment manager to take this large of an amount of capital gains. It would only make sense if this taxable portfolio had nothing but speculative issues in it, which I would find doubtful for a couple in their late 70s. If the taxable account was too high in equities or poorly diversified by industry weightings, adjustments can be made in the larger retirement account to bring the combined account into better balance. It may have been appropriate to take some gains, but they can certainly be spread out over several years, as taking them all at once likely puts the couple in a higher tax bracket.

Answer: You’re making a good point that the couple had other options besides “ripping off the Band-Aid” and incurring one big tax bill rather than taking the gains more gradually. Their new advisor, as a fiduciary, should have discussed the options with them and helped them understand the impacts, including the expected tax bills and potential impact on Medicare premiums. If those discussions didn’t happen, that’s all the more reason to seek out a second opinion from another fee-only financial planner.

Q&A: Can I avoid capital gains by buying another house?

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Dear Liz: We are in our 70s and have owned a home in the San Francisco Bay Area for 30 years, so as you might imagine we have a sizable capital gains issue. We are starting to think about a “next step.” While I understand we would have a $500,000 exclusion and can “back out” any improvements, we would still be looking at a pretty hefty number.

We’ve had some people tell us that we would be able to take advantage of a one-time exclusion for the whole gain, but I certainly haven’t been able to find anything about this. I know if we purchase another home in California, we can keep our existing property tax basis, but in the scheme of things, that’s not a major benefit.

Any idea what these folks might be talking about?

Answer: They’re talking about an option that disappeared not long after you purchased your home. Some people are under the illusion that the old tax break still exists, because versions of this question seem to hit my inbox at least once a year.

Before Congress changed the law in 1997, homeowners could defer taxes on home sales by purchasing another house of equal or greater value. Those 55 and older could take a one-time exemption of $125,000.

That was replaced by rules allowing homeowners to exempt up to $250,000 each (or $500,000 for a married couple), limits that haven’t been updated since.

When the law was passed, few home sellers had enough capital gains to worry about exceeding the exemptions. Consider that the median home sale price in the Bay Area was just under $300,000 in 1997. Last year, the median was about $1.2 million.

A sizable capital gain doesn’t just deliver a painful tax bill. Your Medicare premiums may also temporarily increase, thanks to IRMAA, the income-related monthly adjustment amounts.

One more thing: please don’t dismiss the value of California’s Proposition 19, which allows homeowners aged 55 and over to transfer their property tax basis to a new home.

Your property tax bill is dramatically lower than what you’d pay if you were buying into your neighborhood today. That’s thanks to California’s earlier Proposition 13, which limits annual property tax increases.

A home purchased for $300,000 30 years ago probably has an annual property tax bill today of around $7,000. That same house, if purchased now for $1.2 million, would generate a tax bill of around $15,000.

Your ability to transfer your tax basis means you can save thousands of dollars annually for the rest of your life. That would be a huge benefit in most people’s scheme of things.

Q&A: Was it a mistake to incur a large tax bill?

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Dear Liz: We are a retired couple in our late 70s. I worked as a carpenter and my wife worked as a nurse. We saved and invested for the long haul with a well-known discount brokerage. Last summer, we were wooed by another financial services firm with a “much better idea.” Our combined portfolio at the time was $1,985,000. We transferred our holdings, including $340,000 in a taxable account.

The transfer triggered a capital gain of $184,000 as the new company sold the old funds and reinvested the money according to their plan. This caused us to owe about $50,000 in income tax this year rather than breaking even or receiving a refund. Our holdings have grown to $2,013,119 after our 2026 required minimum distributions have been taken. Was this a good move given the large tax bill? Our tax accountant is very critical of the sale of these funds.

Answer: Your accountant may not be in the best position to evaluate whether this was the right move for you.

Tax pros are typically focused on saving their clients money. That often means delaying or avoiding moves that could trigger capital gains taxes. Sometimes, though, such moves are necessary to avoid even bigger financial costs down the road.

The stock market gains of recent years mean that many people have portfolios that are now too heavily invested in stocks, particularly if they haven’t been regularly rebalancing their investment mix. These stock-heavy portfolios can leave people painfully exposed to downturns.

I redacted the names of the firms, but both companies you mentioned in your letter have good reputations. Your previous brokerage caters to do-it-yourself investors who want to minimize fees, while your new one provides fiduciary advice, meaning that they’re required to put their clients’ best interests first. It’s easy to imagine you investing for decades on your own without an advisor’s help or appropriate rebalancing; the new firm sees how risky your portfolio has become and diversifies it after careful discussions with you about your age, situation and goals.

Imagination is not reality, though, and the most concerning part of your letter is your vagueness about why you moved your money. You should be able to articulate in basic terms why this transfer made sense. “Our portfolio was too risky” or “I had too many of the same type of stocks” or “I realized I needed help” are all appropriate reasons. “A much better idea” is not.

The right move now might be to get a second opinion from a fee-only financial planner. Someone who charges by the hour could review your portfolio and let you know if you’re now on the right track. You can get referrals from the Garrett Planning Network at https://garrettplanningnetwork.com/.

Q&A: Home sale tax rules confuse many

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Dear Liz: I thought I understood about taxes and house sales, but I am now confused. It seems like the previous rules were that home sale profits could be rolled from one house to the next and one would take a one-time exemption for up to $500,000 or so, with capital gains only due on the amount above that amount. Now the latest rule is that house sales are calculated on each sale, but still based on purchase price plus improvements as the basis. Or is it?

Answer: You are confused, but you’re not alone. Many people remember the old rules, and some think they’re still in effect.

The basic way that capital gains are calculated hasn’t changed. The homeowner’s tax basis — which is the amount they paid for the home, plus qualifying improvements — is subtracted from the net sale price to determine potentially taxable capital gains.

Before the Taxpayer Relief Act of 1997, homeowners could defer capital gains on home sales if they bought a replacement house of equal or greater value. At age 55, they could take a one-time exemption that protected $125,000 of home sale gains from taxation. This allowed many if not most people to downsize without owing big tax bills (the median home price in 1997 was less than $150,000).

The rules today are quite a bit different. Home sellers can exclude up to $250,000 of capital gains, or $500,000 for a married couple, as long as they owned and lived in the home at least two of the five years prior to the sale.

Note, however, that the exclusion amount hasn’t changed since 1997. The median home price in the U.S. is over $400,000, and “starter” or entry-level homes top $1 million in over 200 cities, according to real estate site Zillow. That means many more longtime homeowners face capital gains taxes when they sell their homes.

Q&A: How to finance a remodeling project

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Dear Liz: I am doing a small remodeling job to my home that will cost $80,000. I have enough in my investments to withdraw the $80,000. Is it better, tax wise, to get a home equity loan to pay for it?

Answer: Like so many tax questions, the answer depends on your circumstances. How your investments would be taxed depends in part on what account they’re in. Withdrawals from most retirement accounts are taxed as income, and can incur penalties if you take the money out too early.

Withdrawals from regular brokerage accounts also can be taxed as income if you’ve held the investments less than one year. If the investments have been held for more than one year, you can qualify for more beneficial capital gains tax rates. The amount of tax you would pay depends on how much the investments appreciated in value since you bought them as well as your income tax bracket. Most people pay a federal capital gains rate of 15%, although lower income taxpayers can qualify for a 0% rate while higher earners pay 20%.

You may have the opportunity to engage in what’s known as “tax loss harvesting.” That means selling investments that have lost value since you bought them, and using that loss to offset the gains on other investments you’ve sold.

Interest on home equity borrowing, meanwhile, may be deductible if the proceeds are used to improve your home and the combined total of your mortgage debt doesn’t exceed $750,000 for a married couple filing jointly or $375,000 for singles.

To deduct the interest, though, you must itemize your deductions. The vast majority of taxpayers now take the standard deduction of $31,500 for married couples or $15,750 for singles. People 65 and older can take an additional $1,600 per qualifying spouse or $2,000 if single. In addition, people 65 and over can take an additional $6,000 bonus deduction if their income is under certain limits. The bonus begins to phase out for single filers with modified adjusted gross income over $75,000, and for joint filers over $150,000.

That’s the long answer. The shorter answer is that the taxes you’ll pay cashing in your investments are likely to be less, and perhaps significantly less, than the interest you’d pay on the loan. But you’ll need to do your own math, or ask a tax pro for help.

Q&A: Time to move, but what about the capital gains?

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Dear Liz: My husband and I built a home on a hillside over 30 years ago in a desirable neighborhood with a beautiful view. We thought it would be our retirement home, but life had different plans. Now seniors, dealing with age, stairs and progressive health issues, we have been advised that selling and moving to a senior assisted living facility is the best option for us before we are forced by circumstances to move. And, we were told, it would be less expensive than having full-time, in-home care.

We are concerned that capital gains would take a big chunk out of the sales proceeds from our home, and that’s money we need to pay for assisted living. Can we use the purchase price of the vacant lot against the capital gains? Can we use the bank loan for building the house against the capital gains? Can we use the cost of an apartment or condo in an assisted living residence against the capital gains? What other things can be used against capital gains other than general home improvements?

Answer: A large gain wouldn’t just reduce the amount of money you have for the next phase of your life. It also could increase your Medicare premiums for a year, thanks to the income-related adjustment amount or IRMAA.

You’ll determine your potentially taxable capital gains by deducting your tax basis from your home sales proceeds. Your basis includes the purchase price of the lot and the cost of construction, plus any qualifying home improvements you’ve made over the years.

The two of you can shelter up to $500,000 of home sales profits from capital gains taxes. Capital gains also can be reduced if you have capital losses — in other words, if you’ve sold stocks or other assets for a loss.

What you do with money doesn’t affect the capital gains taxes you pay. Decades ago, you could defer capital gains by buying another home of equal or greater value, but that’s no longer the case.

You may have some alternatives to lessen the impact of the gains, such as an installment sale where the buyer pays over time. Another option would be renting out rather than selling your home.

A tax pro can provide guidance.