By Michael Repka, ESQ | CEO & General Counsel
As an estate-planning attorney, I found that many people make major life decisions based on short-term needs rather than developing a long-term, tax-efficient strategy for their real estate holdings. This has the unfortunate consequence of causing their real estate portfolios to develop in ways that are inconsistent with their long-term goals, but there could be even more dramatic—and avoidable—consequences when it comes time to sell. The tax code provides very significant incentives for people to invest in real estate, both for primary residences and investment properties. However, making quick decisions without fully understanding the consequences can have a very negative impact.
One of the most common areas of concern is how elderly homeowners should pass their real estate assets to their children. Elderly homeowners are often faced with the quagmire of whether to sell their property to fund their retirement, or remain in the property and pass it on to their children. The simple and purely financially driven answer is that elderly sellers with a substantial amount of unrecognized gain in their property should not sell their property, if possible. Instead, they should leave it to their heirs and permit their heirs to sell it if they choose.
California and Federal Taxation of Gains on Real Property
Many long-term Silicon Valley homeowners have hundreds of thousands, if not millions, of dollars of unrecognized built-in gains in their homes. Given that the combined maximum capital gains tax rate is over 37 percent, the sale of the property would result in a very large tax liability. While the $500,000 exemption that applies to most couples selling their primary residences helps, this amount may not be enough in light of the significant amount of appreciation.
A simple example may help to illustrate the problem. Imagine a couple who purchased a home in the Crescent Park neighborhood in Palo Alto for $200,000 in 1977. Forty years later, they decide to sell it and retire to Hawaii. The fair market value of the home is $4.6 million—a great investment, and the IRS will think so, too. Over the years, they invested $200,000 in upgrades to the home, and the transaction costs are estimated to be another $200,000. Their basis would be $400,000 (the original cost plus the improvements), and they could deduct the sales expenses. Thus, their gain would be $4 million. Even after subtracting the $500,000 homeowners’ exemption under Internal Revenue Code Sec. 121, the sellers would have a taxable gain of $3.5 million, which would result in the couple having to pay well over $1 million in combined state and federal taxes.
The Upside of Leaving Property to Heirs and Spouses
Death solves so many problems, including that the federal and state taxing authorities will forgive the income tax on the built-in gain on assets the taxpayers owned at the time of death. In the example above, the taxpayers’ heirs would inherit the property with a basis equal to the fair market value of the property at the time of the taxpayers’ deaths. Thus, if the home was sold for that amount (e.g., $4.6 million), they would not have to pay any tax.
Interestingly, when one spouse dies in California, the surviving spouse gets a step-up in basis on the entire value of owned property as community property with rights of survivorship, the most common form of ownership for well-advised clients.
Through earning my second law degree in taxation, I have learned that there are many tax strategies that can help sellers achieve both their personal and financial objectives in a tax-efficient manner. As such, for years DeLeon Realty has been running an advertisement inviting sellers to come in and meet with me to discuss legal and tax issues related to selling.
Naturally, we are fully aware that many people who take us up on this opportunity are not looking to sell right away; they are rather trying to collect information to determine the best long-term strategies for their families. In fact, that was exactly what we were looking to accomplish with this invitation since DeLeon Realty is uniquely qualified to provide tax and legal advice to our clients on these topics. Plus, we really enjoy doing it!
On the other hand, if you do want to sell, then we should meet to discuss ways to reduce, defer, or eliminate tax on the gain.