OT? Ultimate tax dodge

Investment Analysis Clubs Macro Economic Trends and Risks
1

This may be on-topic since millions of people own homes. The timing of sales can have a Macro impact on the property market.

DH and I moved to Washington State in 2003. I paid $185,000 but Zillow says it’s worth close to $485,000 now. (A capital gain of $300,000 which would be tax-exempt if we sold it today…which I don’t want to do since I love our neighborhood where I have several friends.)

I own the home in my revocable trust since I paid for it. My trust says that DH can live in it after my death but it will go to my family instead of DH’s subsequent wife (assuming he will remarry after my death). Our home is a ranch house which is comfortable for aging in place.

https://www.wsj.com/personal-finance/taxes/taxes-home-sale-capital-gains-6a9f09eb?mod=hp_lista_pos2

A Tax Question: Sell Our Home Now, or Wait Until One of Us Dies?

We answer a reader’s thorny question on capital gains

By Ashlea Ebeling, The Wall Street Journal, Jan. 28, 2024

…
One, the home-sale exclusion, lets homeowners skip taxes on a large chunk of profit when they sell their homes—up to $250,000 of capital gains for single filers and up to $500,000 of capital gains for married couples filing jointly.

The other provision says that when an owner dies and leaves a property to heirs, the capital gains can effectively get reset to zero. This is called a step-up in basis, meaning the heir would only owe capital-gains taxes on the home’s growth in value over the fair-market price at the time of the owner’s death…

In most states, for homes jointly owned by spouses, half of the property’s basis is stepped up to the fair-market value at the date of the first spouse’s death, which can help cut an eventual tax bill. The other half keeps the original basis, adjusted for any improvements, until the survivor dies. …

If the surviving spouse hasn’t remarried and sells within two years of the first spouse’s death, the survivor still might also be able to exclude up to the full $500,000 of the gain from the sale, using the home-sale exclusion.

In community-property states, such as California and Texas, the tax advantage is even greater. The entire property gets a step-up in basis to the fair-market value after the first spouse’s death.

Keeping your home until death is one of the ultimate tax dodges. [end quote]

Wendy

4 Likes
2

I wonder if the property taxes are then raised to the new stepped up value?

3

In CA (based on Prop 13) Properties would be fully reassessed in value only when a change of ownership occurs either by death, gift, or sale .

Mike

1 Like
4

In Washington State, home values are reassessed annually. My property taxes have tripled in ten years, but the home value has almost quadrupled. I’m still paying less than 1% of market value, but eventually my property taxes will catch up to 1.0% to 1.1% of market value.

The stepped -up cost basis is the ultimate tax dodge and the foundation of multi-generational wealth in America, as well as inequality. The dumbest thing you can do in America tax-wise, is to work for a living earning wage & salary income. The smartest, is to inherit something with the stepped-up cost basis, and then live off tax-free returns of capital from that asset.

intercst

2 Likes
5

And then in 2020 Proposition 19 was passed which changes the inheritance part.

Up until the February 15th [2021] deadline, a personal residence transferred by inheritance or gift to children is excluded from reassessment, so the children also receive the “low” property tax bill as well. Prop 19, in short, limits this exclusion significantly.

Prop 19 requires that if the home is not used as a child’s personal residence within one year, it is to be reassessed at market value when inherited. Let us look at how it may impact families and the choices they face by looking at a hypothetical example with more details…

DB2

1 Like
6

I have seen some discussion about whether it is worth selling and then buying something else to capture the tax-free gain of up to $500k. For example, someone bought for $200k, now worth $700k. They know they will be moving out into a condo at age 60-65, and then later perhaps to an assisted living place at 80+. So they have a choice. They can keep it, continue living in it, and then sell it in 10 years at $1M, and then owe capital gains tax on $1M - $200k - $500k (exempt) = $300k. That comes to perhaps a $60-71k tax bill. Or they could choose to avoid it by selling now for $700k, capturing the full $500k exemption, and then buying another place nearby (same friends and neighborhood) for $700k, or more likely for $500k because they don’t need as big a home anymore now that the kids have all moved out. Then they restart the clock from $500k, and in 10+ years when they move out (to a condo or to assisted living), they can capture another [portion of the] $500k exemption. Obviously this doesn’t work so smoothly in the real world which is why it is mostly a theoretical discussion (except for @inparadise who has used this technique masterfully). It doesn’t work because most people can’t sell a $700k home, and buy a $500k home, without numerous selling and buying expenses that could, and very likely would, eat up much of the capital gains tax savings. And, of course, moving out of one’s home takes quite a bit of effort and can be traumatic to some extent. A second reason this doesn’t work in the real world is that in some states, property taxes are limited based on when, and at what price, you purchased the home. In CA, for example, if you purchased a home 25 years ago for $200,000, your annual property taxes are likely $4,000 or so today. The house could be worth $700k, and you could consider selling it to capture the $500k capital gains exclusions. BUT, when you buy the next house, let’s say for $700k, then your property taxes will reset, and will be more like $12,000 a year thereafter. After 10 years, you’ve paid an extra $80,000 in property taxes which negates quite a lot of the capital gains taxes you will have avoided.

I’m not so sure there can even be a “timing of sales” because generations are spread out over time. The “boomer” generation is spread out over 20 years, so on average only a small percentage of them will be selling each year over the 20+ year period that they decide to move because of age. Same for the “millennial” generation. There were myriad articles written about that generation, not buying houses, buying fancy coffee instead, not investing in stocks and bonds, not saving for retirement, etc. But sure enough, as each year passes, some percentage of them indeed buy homes, and indeed are saving for retirement, and indeed are investing in stocks and bonds, and are having children, and all the usual things that come with traversing adulthood. But it is spread across time, as each year’s worth of “millennials” age.

3 Likes
7

@thegreatdane property taxes are local and always based on the locally determined property value.
Wendy

8

Let me begin my reply by stating I am no tax professional. It could very well be that there have been recent changes I am not aware of. However, if the home is owned by your trust, I am not sure it is eligible for capital gains exclusion, or certainly not more than $250K, because a trust is a single “person,” and not a couple. You both have to be owners and residents for 2/5 years to get the full $500K, since it is $250K max per spouse. Owning real estate in a trust presents many tax issues that make it less than advantageous.

That said, I typically don’t let the tax tail wag the sale of real estate dog. It is certainly an input I consider, but not a primary consideration. I am using it with the sale of our current residence in evaluating whether or not to turn the property into a rental, which becomes considerably less profitable when you understand you would be giving up capital gains exclusion on hundreds of thousands of dollars. The primary reason for selling, however, is not wanting to live here anymore. To me that’s the primary reason for selling, assuming of course that you can afford the property.

I also believe that there is no step up in basis on death when held in a trust, unless it is the death of a co-trustee. Googling finds this on capital gains exclusion: The principal residence exclusion under section 121 allows an individual or married couple to exclude up to $250,000 or $500,000 of gain on the sale of a primary residence. But since an irrevocable trust is not a natural person, it is typically not allowed to use this exclusion. However, there are a few exceptions.

This capital gains exclusion is not available to trusts, only to individuals. If a trust sells the residence, any gain is subject to capital gains tax and possibly the 3.8% net investment income tax (NIIT).

Sale of Principal Residence by Irrevocable Trust: Top Strategies ».

IP,
hoping you meet the exceptions

1 Like
9

The typical grantor trust used for estate planning would be eligible. Those trusts remain revocable until the grantor’s death, when they typically become irrevocable.

This kind of trust is disregarded as an entity separate from the grantor (the person who created the trust and put assets into it) and does not file a tax return.

However, an irrevocable trust would indeed have the problems you suggest. But those are not typically used for estate planning.

–Peter

1 Like
10

Sigh. We have been saddled with one, designed with the intent to exist in perpetuity. Really mucks things up taxwise, and will do so…forever. Looked at buying real estate with it and was warned not to do so.

IP

11

@ptheland , @inparadise thank you for your valuable discussion. Please allow me to check my understanding.

  1. As a grantor trust, the house would be eligible for the $250,000 exclusion.

  2. DH is the successor trustee. If we were both still alive when the house is sold (filing MFJ) would we qualify for the $500,000 exclusion?

  3. After my death the grantor trust would convert to a credit shelter trust (a type of irrevocable trust meant to shelter part of my trust from state estate taxes). DH would be the trustee. How would that affect the situation?
    Thanks,
    Wendy

12

Assuming DH is still with us, you’d get $500k on a joint return. The grantor trust is disregarded, so you would be treated as owning the house. Only one spouse needs to own the house, but if both are living in it, you would qualify for a $500k exclusion. But you would need to file a joint return.

Successor trustee is irrelevant. Yes, you would qualify.

After my death the grantor trust would convert to a credit shelter trust (a type of irrevocable trust meant to shelter part of my trust from state estate taxes). DH would be the trustee. How would that affect the situation?

DH as trustee is irrelevant. Because you are treated as owning the house immediately before your death (remember, the grantor trust is disregarded), the house would get a full step up in value. The trust is considered to inherit the house. But from that point, there would be no further exclusion. DH would not own the house, so he wouldn’t qualify for an exclusion on his own.

–Peter

PS - Be sure to check in with a lawyer on the need for updates to your trust, particularly as the current estate exemption is changing from roughly $13 million currently to around $6 million in a couple of years.

5 Likes
13

Thanks Peter. I appreciate your correcting my incorrect understanding. Other’s chiming in to correct information is one of the main strengths of these boards.

IP

4 Likes