Long time followers of my newsletter have seen my other installments of the “Ask a Professional” series, and since we are already at that fun time of year we call “Tax Season,” I thought I would share with you some commonly asked questions I hear regarding taxes and property, and have Tax Attorney Johan Deprez answer them for you. He practices in the state of California in the country of the United States of America, so these answers pertain to this location primarily. And, these are general answers; you need to seek the advice of a professional should you have specific questions about your particular circumstances.
Without further delay, here are the Questions along with his Answers….. let me know what you think and if you find this helpful.
1) If I want to sell my home, but I know that it has gone up more than $250,000, will I have to pay tax on the increase above $250,000? If so, how much?
Federal and California income tax on the sale of a property is calculated on the gain realized from that sale. This gain is the proceeds from the sale minus selling expenses and minus the original purchase price adjusted for certain buying expenses and improvements to the property (adjusted basis). This gain is typically different than the equity in the property (market value minus outstanding mortgage amounts) or the cash received from the sale. On the sale of one’s main home, $250,000 of the gain ($500,000 for a married couple filing taxes jointly) is excluded from income tax if this main home was owned for more than two years, was lived in as the main home for at least two of the last five years, the exclusion hasn’t been taken on another property for at least two years, and certain other conditions are met. If any of the gain not excluded, the taxable amount is likely taxed at 15% or 20%, with a possible 3.8% additional amount, at the federal level, and at income tax rates ranging from 0% to 12.3% (9.3% is most likely) at the California level. Often it is wise for homeowners to obtain a professional estimate of what the tax implication of the sale will be and what the after-tax cash proceeds will be.
2) I know that married couples get a tax free amount for their home’s increase of $500,000. What if I get a divorce or my spouse passes away, or goes into a nursing home and isn’t competent to sign anymore? Do I still qualify for the $500,000 tax free, or is there a point that I would only qualify for $250,000 tax free?
Even with the sale of the main home, the facts and circumstances surrounding the sale often get complicated either because of the nature of the property or the situation of the owners (such as a recent divorce, the passing of a spouse, or the incompetency of a spouse). The amount of the exclusion available ($250,000 or $500,000) depends on the tax filing status of the person selling the home. So, recently divorced or widowed person are filing single and are only eligible for the $250,000 exclusion. However, death of a spouse or divorce where one spouse “buys-out” the other, typically increases the adjusted basis of the property and reduces the taxable gain. The exact amounts of these changes depend upon how the property is held (e.g. joint tenancy, community property, community property with right of survivorship, etc.), the state in which the main home is located, and other pertinent facts and circumstances.
3) I have a property that I use as a rental and I heard I can do a 1031 exchange or tax deferred exchange. How does that work? Do I have to buy a more expensive property? How much time do I have to do it?
A Section 1031 exchange is a method by which the income tax associated with the gain on an investment property can be deferred until the owner finally “cashes out.” It only applies to situations where an investment or business property is exchanged for another investment or business property. The exchange must be for “likekind property.” Most real estate, as long as it is in the United States, qualifies as likekind property. For example, a condo, a fourplex, and a strip mall are all likekind property and qualify as long as they are held for investment or business purposes. Time wise, the key conditions are that the replacement property needs to explicitly “identified” within 45 days of the sale of the original property and closed on with 180 days of the sale of the original property. For a pure Section 1031 exchange to work, all the proceeds of the sale of the relinquished property need to be put into the replacement property and debt incurred with the replacement property must be larger than the mortgages on the relinquished property, meaning that the replacement property is usually of higher value than the sale price of the relinquished property. The owner must never have control of the funds associated with the transaction. There are many variations on a Section 1031 exchange possible and other conditions that have to be met, so an expert should be consulted. In addition, it is usually wise to have an estimate of the taxes that could be saved to be done in order to determine if a Section 1031 deferral is really the best way to proceed.
4) I’m over 55 and I want to move. I heard I can keep my low tax base if I move. How does that work?
California property tax is primarily governed by Proposition 13 and administered at the county level. The assessed value for property tax purposes is usually set by the price at which a property is purchased. Then small increases (maximum of 2% and a few other possible charges) are added each year. There are a variety of exceptions to this general rule available to California homeowners. One is the Senior Citizen’s Replacement Dwelling Benefit by which a qualifying homeowner can take the property tax basis from their previous principal residence and apply it to their new principal residence, if that replacement principal residence is of equal or lesser value. For example, if the current residence has a value and sales price of $500,000 and a property tax basis of $200,000 and the qualifying homeowner buys a $400,000 new principal residence, then the homeowner can apply to use the previous $200,000 basis, instead of the normal $400,000 purchase value, as the basis for property taxes for the replacement principal residence. Note that this benefit applies within each county in California, but may not apply when homeowners move between counties (e.g., Orange and Los Angeles counties have reciprocity; Santa Barbara county doesn’t have reciprocity). Also, this benefit is not automatic and needs to be applied for and other conditions need to be met.
This concludes my interview with Johan Deprez. If you liked what you read, please let us know! You can reach Johan at Johan@DeprezLaw.com or 562-841-1600 or find further information at DeprezLaw.com.