by Michael Repka
Owning real estate is part of the American Dream; a dream that is fully supported by federal and state tax policy. Both the federal government and Sacramento offer numerous tax incentives that encourage people to buy real estate, especially the home in which they live.
Conversely, due to the strong appreciation of the Silicon Valley housing market, there are some significant tax rules that may serve as a disincentive to selling. Homeowners should be cognizant of all tax consequences when deciding whether or not to sell.
Capital gains tax erodes equity
Capital gains taxes are the most obvious cost to selling real estate that has appreciated over time. In 2012, the combined federal and California tax bite on the gain on real estate was almost 25 percent for taxpayers in the highest California tax bracket. Bear in mind that, unlike the federal government, California does not offer preferential tax rates for capital gains. Worse yet, these rates should be significantly higher going forward due to the passage of Prop. 30, which established higher income-tax brackets for individuals earning more than $250,000 ($500,000 for married couples filing jointly), and a new 3.8 percent tax passed as part of "Obamacare." Further, there have been numerous calls to raise capital-gains rates above the 15 percent applicable in 2012. Although married couples filing jointly may be able to exclude up to $500,000 in gain on their primary residence, many in Silicon Valley are sitting upon gain well in excess of this limit.
After much debate, Prop. 13 was passed in the late '70s. Under Prop. 13, property values for tax-assessment purposes were pegged to the then-current property value and each property was taxed at the rate of 1 percent of that value. Further, the maximum annual increase to the property's assessed value was set at 2 percent unless there was a change in ownership. Because Silicon Valley prices have generally gone up far faster than 2 percent per year, many long-term homeowners are paying substantially less property tax than they would if they sold and bought the identical house next door. Therefore, unless the taxpayer qualifies to transfer their property-tax value to their new house, they will lose their preferential property-tax rate if they sell their home.
Loss of basis step-up
One of the biggest tax costs to selling, which is often overlooked, is the loss of a basis step-up upon death. Although simplified, taxpayers are generally taxed on the difference between the selling price of their home and what they originally paid (including the cost of capital improvements to the home). However, under current IRS rules, the basis of the home (original cost plus improvements) is adjusted to the fair-market value of the home as of the date of death of the owner. If properly structured and held, this generally beneficial adjustment is made even if only one of the spouses passes away. However, if the property is sold prior to death, the entire gain may be subject to tax. Thus, elderly homeowners may be better served holding on to a highly appreciated property until their passing.
Incentives to sell
While there are a number of disincentives to selling, there are currently a few tax incentives as well. First, the federal capital-gains rate is generally considered low when compared to the historical average. Even if the rate increases from 15 percent to 23.8 percent it is still lower than the 28 percent rate that was in place in the '90s. Many commentators feel that the capital-gains rates are more likely to go up than down in coming years.
Additionally, Internal Revenue Code Section 121 provides an exemption for the first $250,000 in gain for most taxpayers ($500,000 if married filing jointly) when they sell the personal residence in which they have lived for at least two of the past five years. However, any gain in excess of these limits is subject to tax. Therefore, taxpayers that are approaching $500,000 in gain would benefit from selling and purchasing a new home, thus starting the climb towards the $500,000 limit all over again.
Before deciding to sell a home, it is generally a good idea to speak with a tax professional or experienced real-estate agent about any possible opportunities to limit the tax bite. The right timing and approach could result in significant savings.