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home sale

Q&A: Counting freeloading relatives as a hardship? Not so fast, the IRS says

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Dear Liz: I lived in a house for 45 years. During that time, my daughter and her family moved in due to the 2008 financial crisis. I have not charged her rent. However, I moved out five years ago, and her family is still there rent-free. I understand that when I sell, I will owe capital gains tax because it is no longer my primary residence. Are there any hardship rules that may help me?

Answer: Unfortunately, the IRS doesn’t consider freeloading relatives as one of the hardships that can modify the home sales exclusion rules.

Your capital gain will be calculated by subtracting your tax basis in the home from the sales proceeds, minus selling costs. Your tax basis is generally what you paid for the house, plus the cost of qualifying upgrades.

You can exclude up to $250,000 of home sale capital gains (or $500,000 if married filing jointly), but only if you’ve owned and lived in the property as your primary residence for at least two of the past five years. There is a partial exclusion for people who fall short of the two-year mark because of certain reasons, such as a work- or health-related move.

Q&A: Losing a home in a fire, then being hit with a ‘casualty gain’

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Dear Liz: My house was burned down in the Palisades fire. I lived in the house for 25 years and lost everything. I thought there may be a silver lining with tax deductions. Much to my surprise, I am supposed to use the purchase price from 25 years ago as my adjusted cost basis. The insurance settlement is not going to be enough to rebuild but is more than my cost basis. I will end up with “casualty gain” instead. Is this possible?

Answer: After losing your home and finding out you were underinsured, the news that you might have a taxable gain must have been a gut punch.

The IRS calls it an “involuntary conversion” when your property is destroyed and you receive insurance proceeds. If the insurance payment exceeds your tax basis in the property, that’s known as a casualty gain.

You can defer tax on this gain if you use the insurance payout to rebuild or buy a replacement property, says Mark Luscombe, a principal analyst with Wolters Kluwer Tax & Accounting. Normally you’d have two years to use the insurance proceeds, but in a federally declared disaster such as the Los Angeles fires, the deadline is extended to four years.

The IRS may be willing to further extend the deadline under some circumstances, such as contractor delays, Luscombe says. But don’t count on an extension if you’re simply unable to find a replacement property.

If you do purchase a new home elsewhere, any gain from the sale of the lot where your previous home stood also would have to be reinvested in the new home to avoid a current tax on the gain, Luscombe says.

However, the home sale tax exclusion also applies to involuntary conversions. The exclusion allows you to shelter up to $250,000 of gains ($500,000 if married filing jointly) on a sale or involuntary conversion, as long as you’ve owned and lived in the property as your primary residence for two of the last five years. So you could exclude that amount of gain and defer the rest if you rebuild or find a replacement property, Luscombe says.

This is complicated territory, so please make sure you hire a tax pro to guide you.

Q&A: Sale of last home can trigger capital gains taxes

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Dear Liz: I am 74 and my husband is 68. We have decided to sell our last home and rent. Do we have to pay taxes, specifically capital gains, on the sale of our last home or are we able to keep the sale proceeds in full?

Answer: Any home sale is potentially subject to capital gains taxes. Your gain is determined by subtracting your tax basis — the price you paid for the home, plus any qualifying improvements — from the net sales proceeds. If you owned and lived in the home as your primary residence for at least two of the previous five years, you can exclude up to $250,000 (or $500,000 if married filing jointly) of home sale profits. You would owe taxes on the capital gains that exceed those limits.

A large-enough capital gain could affect how much you pay for Medicare. The “income-related adjustment amount,” or IRMAA, is based on your income two years prior, so a big gain in 2025 could increase your premiums in 2027.

You’d be smart to talk to a tax pro before you sell so you understand the ramifications.

Q&A: Elderly and cash-strapped, a couple consider a proposal to sell their home to neighbors

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Dear Liz: I’m 80 years old and my wife is 76. Our only retirement income is Social Security, and we have less than $50,000 in savings. We have about $600,000 equity in our house, which we bought in 1971. We presently have property taxes deferred, at 6% interest. The house is in disrepair.

We have two neighbors who are willing to buy the house after one or both of us die. The neighbors are willing to postpone occupancy and contribute to mutually agreed-upon home repair costs, which will be deducted from the selling price. Details will all be in the contract. These payments will greatly improve our lives. What could go wrong?

Answer: Well, a lot, which is why you need an experienced real estate attorney to represent you if you go ahead.

It’s not clear from your letter if your neighbors are locking in a sale price now, which would mean you and your wife (or your estates) would give up future price appreciation. Are the payments simply contributions toward the repairs or are they purchase payments? Also, what happens if you need to tap your equity to pay for long-term care? If you or your neighbors want out of the deal, would that be possible? Those and many more details need to be thought through.

But your situation, and your proposed solution, are not that unusual, says Los Angeles estate planning attorney Burton Mitchell. Many older people with highly appreciated properties don’t want to sell their homes and trigger taxable gains in excess of the $250,000-per-owner home sale exclusion.

Another alternative to consider is a reverse mortgage, which could allow you to tap your equity while you remain in the home. You wouldn’t have to make payments on this loan, and the balance would not be due until you and your wife die, sell the home or move out.

Q&A: Homeownership can be a joy. It’s also full of complicated financial decisions

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Dear Liz: We replaced our original, fire-vulnerable cedar shake roof with 40-year asphalt shingles 17 years ago. I know that home improvements are added to the basis for capital gains calculation when selling the home. But when we get ready to sell the home in a few years, should the actual cost on the project be used? Or, since it was several years ago, should we calculate what a “present value” of the 2007 dollar amount would be? For that matter, should the purchase price of the home be updated to a present value?

Answer: You don’t have to discount the costs of home improvements, but you also don’t get to boost your tax basis to reflect your home’s appreciation.

To review: Your tax basis is the amount you paid for your home, plus the cost of qualifying capital improvements — projects that added to the value of your home, extended its useful life or adapted it to new uses. The tax basis is subtracted from home sale proceeds to determine the potentially taxable capital gain. If you’ve lived and owned a home for at least two of the five years before the sale, you can exempt $250,000 of home sale profits per owner.

Keeping good records of your improvements has become increasingly important over the years, because that exemption amount hasn’t been updated since it was established in 1997. Back then, the median home sale price was less than $150,000 and most home sellers didn’t have to worry about capital gains taxes. Today, the median sales price nationally is over $400,000 and there are hundreds of cities where the typical home is worth $1 million or more, according to real estate site Zillow. That means more sellers are facing capital gains that could be reduced if they have the paperwork to prove they made qualifying improvements.

You can’t include the cost of maintenance or repairs, such as painting, patching or replacing broken hardware. If the repair is part of a bigger project, though, it may qualify as a capital improvement. Replacing a broken window pane is considered a repair, for example, but replacing the whole window is a capital improvement.

You also can’t include in your cost basis any improvement that was subsequently removed or redone. If you’d replaced your roof previously, for example, you couldn’t include that earlier expense when calculating your basis.

Q&A: Closing the case on the couple moving into their rental property

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Dear Liz: You recently answered a question from a couple who wanted to move into their rental property, make it their primary residence and use the $500,000 home sale exclusion if they sold the property after living there for two years. You should have made it clearer that not all of the gains on the property would qualify for the exclusion.

Answer: Quite right. In 2008, Congress closed the loophole that allowed people to exclude all the gains when they turn rental property into their primary residence. So the couple would not be able to count the gain that occurred between 2009 and whenever they move in. They would, however, be allowed to include the gain from 1988, when they bought the property, through 2008, as well as any increase in value after they move in if they live in the house at least two years, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

In some parts of the country, there may not be enough gains from those two periods to qualify for the full $250,000-per-owner exclusion, especially after accounting for the depreciation recapture, which requires landlords to pay back the depreciation tax break when they sell a rental property.

In higher-cost areas, however, there still could be more than $500,000 of qualifying gains, Luscombe says.