Tax Savings for Single Homeowners

By Julian Block

Some recently-widowed homeowners who realize profits on sales of their principal residences will benefit from legislation enacted on Dec. 20, 2007, and known officially as the Mortgage Forgiveness Debt Relief Act of 2007. The legislation liberalizes rules already on the books that allow sellers to “exclude” — that is, avoid taxes — on some, and perhaps all, of their capital gains.

More on the revised rules in a moment. As for the existing rules that were introduced in 1997, they generally excluded profits of as much as $500,000 for married couples who file joint returns and $250,000 for those who file single returns or married couples who file separately. Remember — the exclusion refers to the profits, not the sales price, and those $500,000 and $250,000 amounts are caps on the exclusion. Profits above the caps are taxed at a maximum rate of 15 percent on long-term capital gains, plus applicable state and local income taxes that can be claimed as itemized deductions on Schedule A of Form 1040.

But upper-middle and high-income itemizers often are unable to claim their entire deductions on Schedule A for state and local levies, whether on income or on year-round residences, second homes or other kinds of real or personal property. They lose a portion of their allowable write-offs for state and local income, property and sales taxes, as well as for most other itemized deductions when their adjusted gross income exceeds a specified amount indexed — revised upward — each year to reflect inflation: $159,950 for 2008 (up from $156,400 for 2007), declining to $79,975 for married persons who file separate returns. The disallowance is one percent of the amount by which AGI surpasses the designated amount for 2008 and 2009 (down from two percent for 2007 and 2006 and three percent for earlier years). In other words, every $10,000 of AGI above $159,950 results in the loss of $100 in total itemized deductions for 2008.

Then, too, there is the alternative minimum tax, whose many disallowances include all itemized deductions for state and local taxes.

On the plus side, that profit exclusion is not a one-time opportunity. Sellers may claim the $500,000 or $250,000 exclusion each time they sell their principal residence, but generally not more frequently than once every two years.

One admonition: The full exclusion is available only for sellers who meet two simple tests. First, they have owned and lived in the property as their principal residence or main home for periods that aggregate at least two years out of the five-year period that ends on the date of sale. Second, they have not excluded gain on another sale of a principal residence within the two years that precede the sale date.

The Internal Revenue Service allows sellers to meet the ownership and use tests during different two-year periods. Those periods do not have to overlap or be continuous, as when an apartment renter buys her apartment after the building changes to a condo and moves elsewhere before she sells the apartment. However, the IRS is unyielding on its requirement that the seller meet both tests during the five-year period ending on the date of the sale. But the agency does not insist that the property be used as a principal residence at the time of its sale. An example: someone who occupies a home for the first and fourth years during the five-year period nonetheless qualifies for the exclusion.

Another consideration is that short-term or seasonal absences, such as for medical conditions or summer vacations, count as periods of use. But longer breaks do not. A one-year sabbatical leave, for example, is not considered a short temporary absence.

There is a limited exception to the use test for individuals with disabilities. The exception authorizes relief for someone who becomes incapacitated — unable to care for him- or herself — but has lived in the home for periods that total at least one year during the five years before the sale. Under this exception, a disable person can count time spent in a licensed facility (such as a nursing home) for the purpose of satisfying the two-year requirement.

Moreover, the “principal residence” is not limited to the traditional single-family home, but may, in fact, be a condo, co-op apartment or house trailer.

Sellers who are ineligible for the full exclusion because they because they do not meet the ownership and use tests or because they used the exclusion in the sale of another home within the previous two years that end on the date of the current sale still might qualify for a reduced or pro-rated exclusion — provided the primary reason for the sale satisfies any one of three exceptions: The first is a change in place of employment; health problems constitute the second. The third is certain unforeseen circumstances that “could not reasonably have been anticipated before buying and occupying the home.” As spelled out by the IRS, these unforeseen circumstances include, for example, divorce or legal separation, multiple births from a single pregnancy, and natural or man-made disasters or acts of war or terrorism that cause residential damage. Among circumstances not included are a seller’s desire for a different home, incarceration, environmental problems or a long-term decline in the real estate market.

The IRS even permits an individual to use the property for business reasons, as when a specifically definable portion of the house is used regularly and exclusively as a home office. Or the property can be used for investment purposes. All, or a portion of it, could be rented out as long as the rental periods aggregate less than three years and the taxpayer satisfies the use test at the time of sale.

Recently-widowed spouses should familiarize themselves with liberalized rules that grant them more time to sell and still qualify for the $500,000 joint-filer exclusion. This break for surviving spouses took effect at the start of 2008. To illustrate how the old rules and the revised ones work, let’s apply them to widow Mabel and her deceased husband, Mack.

The pre-2008 rules allowed Mabel to exclude up to $500,000 only if she passed two tests. First, she completed a sale of their dwelling not later than the end of the year of Mack’s death. Second, Mabel filed a joint return for that year. (When one spouse dies during the year, the other can still file a joint return for the year. This is an exception to the standard rule that a person’s marital status on Dec. 31 determines whether the person is considered married for that year.)

Contrast “Mack A”, who channels his inner woman and is considerate enough to die on Jan. 2, —thereby giving Mabel until Dec. 31 to sell and exclude $500,000 — with “Mack B”, who is unconcerned or unaware of the rules and dies on Dec. 29, giving her all of two days to sell and exclude $500,000. In any event, a Mabel who is unable to meet the end-of-year deadline gets to exclude no more than $250,000 — the limit for unmarried persons. An additional $250,000 of gain taxed at a top rate of 15 percent adds $37,500 to her tax tab. Add to that any state and local taxes that might prove to be nondeductible if she runs afoul of the alternative minimum tax.

For 2008 and subsequent years, (assuming Mabel has not remarried as of the date of the sale) she qualifies for the $500,000 exclusion as long as the couple jointly owned and occupied their home and she sells within two years of Mack’s death. But what if a moribund market causes Mabel to miss the two-year deadline? The old rules remain applicable and cap her exclusion amount at $250,000. Whether Mabel passes or flunks the deadline, Internal Revenue Code Section 1014 authorizes an exceptional condolence gift for inheritors of appreciated property. Even without an exclusion of up to $500,000, Mabel sidesteps capital gains taxes on part or all of the gain that built up while Mack was alive. On Mack’s death, their home’s basis — the amount by which gain or loss is determined at the time of sale — is “stepped-up” from its adjusted basis (usually, original cost plus improvements) to its value on the date of death. (In certain cases, an estate’s executor has the option to use the property’s value six months after the date of death.)

The step-up covers at least Mack’s one-half interest, assuming the couple owned the property in joint ownership with the right of survivorship. If they live in a community property state, the step-up is for the entire basis, as explained below. There is no step-up for Mabel’s one-half interest.

Mabel and other heirs benefit from forgiveness of capital gains taxes on part or all of pre-inheritance appreciation and, on subsequent sales, tax liability only on post-inheritance appreciation. When an asset has appreciated substantially over a lengthy holding period, the step-up in basis can translate into a considerable savings on taxes.

An example: Mack and Mabel buy their first home for $250,000. They add improvements of $50,000, increasing their jointly owned home’s adjusted basis from $250,000 to $300,000. When Mack dies, the place is worth $1,000,000. His one-half interest is stepped-up from $150,000 to $500,000. Mabel’s share of the adjusted basis continues to be her original $150,000. So her stepped-up basis becomes $650,000 — the sum of $500,000 plus $150,000. Mabel does not remarry, and her home continues to appreciate. She adds no improvements and subsequently sells her home for $1,750,000, resulting in a gain of $1,100,000 — the excess of the sales price of $1,750,000 over her stepped-up basis of $650,000. A sale within two years of Mack’s death means Mabel excludes $500,000 of the gain and owes capital gains taxes on the remaining $600,000. If she misses the two-year deadline, Mabel excludes just $250,000 of the gain and owes taxes on the remaining $850,000.

The joint ownership rules do not apply if Mack and Mabel live in one of the community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In those nine states, there usually is a step-up in basis for all of their community property. If at least one half was included in Mack's estate, then Mabel is considered to have acquired her share (the part not included in his estate) by inheritance. At the date of Mack’s death, there is a step-up in basis for both his and her interests.

In the previous example, assume the home was owned as community property. Then the basis would step-up to $1,000,000. A sale by Mabel for $1,750,000 that is offset by a basis of $1,000,000 drops her gain to $750,000. Should the sale be within the two-year period, Mabel excludes $500,000 of the gain and owes taxes on the remaining $250,000. If not, she excludes just $250,000 of the gain and owes taxes on the remaining $500,000.

A major uncertainty for Mabel and other inheritors is that the step up in basis is mired in a legislative limbo. Beginning in 2010 (in conjunction with the scheduled elimination of the estate tax), the law imposes a ceiling on the amount of property eligible for a stepped-up basis. This restriction allows an estate to increase the basis of assets by no more than $1.3 million. It also allows a surviving spouse who receives assets from an estate an extra basis step-up of as much as $3 million.

Assuming there is no extension of the estate tax repeal, the current stepped-up basis rules again take effect in 2011. But the cap on the step up might be further revised or even undone between now and 2011. Keep tuned.

Julian Block, an attorney in Larchmont, N.Y., is a leading tax professional.