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Real Estate Marketplace Observations by Scot Campbell – Real Estate Broker
BACKGROUND: The sale of a significantly appreciated personal residence often requires the payment of substantial capital gains tax on the profit exceeding the $250,000 per spouse IRS Section 121 threshold.
Some long-term homeowners are fortunate enough to have much more appreciation: $1 to $4 million is certainly not uncommon in Coastal Orange County. There is little appetite for such long-term homeowners to sell when capital gains taxes can take 35+ percent of the profit over the $250,000 per spouse threshold.
HOMEOWNERS OFTEN ASK ME: How can I reduce capital gains taxes when selling my long term home now that I want something more suitable for my current lifestyle (or budget)?
Option #1: There is little or no capital gains taxes due if Stepped Up Basis is applicable: The “step-up in basis” is part of the IRS inheritance tax rules that allow surviving spouse inheriting an asset to use the fair market value of the asset at the time of inheritance as the cost basis for taxes when the asset is sold.
Translation: A widow(er) who has lived in the long term principle primary residence can sell the property and have very little or no capital gains taxes due relating to the appreciation which occurred from the date of purchase until the date of death of their spouse. Additionally, if after the date of death of their spouse the home has appreciated $250,000 or less, and the home has been the principle primary residence of the surviving spouse for 2 out of the last 5 years, then there will be no capital gains tax due for the period after the date of death until the sale (IRS Section 121).
So, when Stepped Up Basis is applicable, there is no “capital gains tax” reason which would limit the desire of a widow(er) to downsize to another property or relocate closer to family or friends.
Furthermore, Proposition 19 has eliminated the transfer of the low property tax assessment to adult children who inherit the home, unless they move into the property making it their principle primary residence. So, after Proposition 19, there is no incentive to keep the family home so adult children can inherit it to keep as a “rental”.
Option #2: Rent Out Existing Home, then Buy or Rent a More Suitable Home: A very simple option is to rent out the existing home, and then Buy (if you can qualify without the sale of the existing home) or Rent a home which is better in terms of location, layout, size, and monthly budget. Rental income from existing home funds the payments (or rent) on the new home.
Important: The existing home reduced capital gains rate (IRS section 121), $250,000 profit exemption per spouse, expires on the 3-year anniversary of the date you move out (so selling before the 3 year deadline is advisable). Or, once the existing home is considered a “rental” under the tax code, you could potentially do a 1031 Tax Deferred Exchange into another rental property which has better cash flows or is better located for ease of management. When the existing home is rented out for the long run or exchanged into another rental, the equity in the existing home has been converted to “an investment” which generates income. The rental income is taxable, but capital gains taxes are deferred.
Option #3: Sell Existing Home using a Traditional Installment Sale: One well known strategy for homeowners (who own their home Free & Clear) is to defer and potentially lower capital gains taxes by breaking up the cash flows from the sale over several years using a Traditional Installment Sale (Seller Carry Back Loan). Home sellers like that Interest income from the carry back loan is higher than a bank savings account, and it is nice to collect interest income on money that would have been paid in taxes (if all proceeds were paid out at close of escrow). Although a large down payment can reduce risk to acceptable levels, some home sellers do not like the risk of missed or late payments and would prefer not to worry about an “early payoff” (which would trigger capital gains taxes).
Option #4: Sell using a Structured Installment Sale: A strategy with less credit risk which homeowners are using to break up the cash flows from the sale over several years is the “Structured Installment Sale” with installment payments made by *A+ Rated Life Insurance Company. Unlike a Traditional Installment Sale, the (annuity) payments are reliably made, and there is no risk of an early payoff.
Other things homeowners like about Structured Installment Sales: The house does not have to be Free & Clear. At closing, the buyer obtains a new loan (or pays cash), and the existing mortgage is paid off. A “chunk of money” can be taken out of the escrow to buy another home (verify tax considerations for these funds), then the balance of the escrow proceeds are taken in the form of reliable monthly installments (annuity from *A+ Rated life insurance company at possibly a much lower capital gains tax rate than if all the funds were paid at the closing).
Important – This article is Not Intended to be specific tax advice: Receiving rent or installment payments from either type of Installment Sale tends to be more beneficial under the tax code when ordinary income is low (often when one is retired). Do NOT sell a highly appreciated home/investment property or attempt to do a 1031 Exchange, Installment Sale, or Structured Installment Sale without advice from a CPA/Tax/Legal Expert who understands your complete situation. Advice and council of a Realtor and Qualified Insurance Broker who are familiar with the IRS rules & best practices are an absolute necessity prior to entering into a purchase contract involving a Structured Installment Sale. *A+ Rating from AM Best.
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SCOT CAMPBELL | Global Luxury Property Specialist | Coldwell Banker-Campbell Realtors
714.336.0394 Mobile / scot@campbellrealtors.com / www.scotcampbell.com / DRE #00943759
