Home values are up, but should you sell?

Market Watch

By Bill Bischoff

Many residential real estate markets finally seem to be getting better. In fact, some are getting a lot better. That means there are more people with hugely appreciated homes. If you fit into this category, please don’t sell without considering the heavy tax hit that would result.

Selling a Hugely Appreciated Home: The Basics

If you sell a hugely appreciated principal residence, your profit will likely exceed the federal home sale gain exclusion. That means part of the profit will be taxed as capital gain (unless you have offsetting capital losses). The maximum exclusion is $500,000 for married couples; $250,000 for singles.

If you sell a hugely appreciated home that’s not your principal residence, you get no gain exclusion break. So the entire profit will be taxed as capital gain (unless you have offsetting capital losses).

Example: You and your spouse bought your home many years ago for $200,000. Over the years, you made $150,000 in improvements, so your tax basis in the property is $350,000 ($200,000 plus $150,000). If you sold the place, you would net $2.5 million. Your Form 1040 would show whopping taxable gain of $1,650,000 ($2,500,000 sale price minus $350,000 basis, minus $500,000 exclusion).

If the same numbers applied to a vacation home, selling would trigger an even more whopping $2,150,000 taxable gain ($2,500,000 sale price minus $350,000 basis), because there’s no gain exclusion break for vacation homes.

Tax Rates Are on the Rise

A big tax gain is one thing. The actual tax hit depends on the applicable rates. Here’s the bad news.

Federal Capital Gains Tax: The Bush tax cuts will automatically expire at year-end unless Congress takes action and President Obama approves. With a profit from selling a hugely appreciated personal residence, the relevant issue is the maximum federal long-term capital gains rate. Without a law change, that rate will automatically rise from the current 15% to 20%. Congress might limit the 20% rate to “millionaires,” but that would include folks with massive home sale gains. Plan on a 20% maximum rate, and hope the actual rate turns out to be lower.

New 3.8% Medicare Surtax: Starting next year, higher-income individuals will owe the new 3.8% Medicare surtax on all or part of their net investment income, which will include the taxable portion of gain from selling a principal residence and gain from selling a vacation home.Read Taxmageddon May Wallop Home Sellers

State Capital Gains Tax: Most states with personal income tax regimes hit capital gains, including home sale gains, at the same rates as ordinary income. If you live in California, where many hugely appreciated homes happen to be, there’s a brand-new 13.3% maximum state income tax rate. If you live in New York City, the maximum combined state and city income tax rate is 12.9%. Other states have lower rates. (If you live in a state with no personal income tax, you only have to worry about the federal tax hit.)

Adding the Rates Up

If you have an ample home sale gain in 2013 or beyond, the federal tax hit could be as high as 23.8% (20% capital gains rate plus 3.8% Medicare surtax).

If you live in California or New York City, the state and local tax hit on a big home sale gain could be around 13%, which would amount to a combined federal, state and local tax rate near 37%. Yikes! You do the math on a $2 million taxable home sale gain.

While tax rates in other states are lower, they can still be painful.

The Tax-Saving Solution: Hang on Until the Bitter End

The basic tax-saving strategy in the hugely appreciated home scenario is to do nothing. Hang on to the home. Don’t sell it! Here’s why. For federal income tax purposes, the tax basis for the portion of a personal residence that you own is stepped up to fair market value (FMV) as of (1) the date of your death or (2) six months after your death, if the executor of your estate so chooses. (Source: Internal Revenue Code Section 1014(a).)

• If you’re the sole owner of your home, the basis step-up rule applies to the entire residence after you die. When your heirs sell the property, federal capital gains tax will only be due on the additional appreciation (if any) that occurs after the magic date.
• If you and your spouse own the property together, the tax basis of the portion you own will be stepped up when you die. The tax basis of the remaining portion will be stepped up when your spouse dies. Once again, your heirs will probably owe little or nothing to Uncle Sam when the property is sold.
• If you and your spouse own the home as community property in one of the nine community property states (one of which is California), the tax basis of the entire residence is generally stepped up to FMV when the first spouse dies — not just the half that was owned by the now-deceased spouse. This weird-but-true rule means the surviving spouse can then sell the place and owe little or no federal capital gains tax. (Source: Internal Revenue Code Section 1014(b)(6).)
• If these taxpayer-friendly basis step-up rules apply in your state, the hang-on-to-your-home strategy will work the same tax-saving magic for state income tax purposes too.

The Bottom Line

Doing nothing is not usually a great tax-planning strategy, but the hugely appreciated home scenario is an exception. One more thing: If you think you can’t afford to hang on to your home until the bitter end, consider taking out a reverse mortgage to get the cash you need. The interest and transaction costs of a reverse mortgage could be a very small fraction of the tax cost you can avoid by hanging on to your home.