What Will my Taxes Look Like upon Sale?

Racing the clock so you get to the plant sales......  

Clients have been asking me questions about the details of selling their long-held home--as they should!  It's an important transaction involving what's likely to be your largest asset.

 I always say, "I'm not your attorney nor your tax advisor, so check with them, but in the main, ....."  Issues range from how much taxes will be due/how much they will net for the future, to how to coordinate selling and buying in a convenient time frame, to whether it's risky--or possible!--to buy a new home before circling back to sell the old, to are there ways to avoid taxes or property tax increases (given that Prop 13 suppresses your property tax bill in your current home).  I've covered many of these issues before, but will reiterate in the next couple of months.

I've asked Piedmont tax advisor, Dean Emerita and current professor of the Golden Gate University Braden School of Taxation, Mary Canning to answer the most common questions I get.

1.  In the main, what kinds of taxes are due to the US and California when you sell your home?  Can you assume a $1 million purchase price, $2 million sale price and $200,000 of transaction costs (escrow fees and brokerage costs when I bought and sold, and paint and new carpet when I go to sell)?

Assuming taxpayers are married filing jointly, and they have lived in their home as a principal residence for 2 of the previous 5 years before the sale, the taxes would be calculated as follows:

 $2,000,000 sales proceeds

-$140,000 (combination of commissions paid, selling costs, escrow fees, staging and other fix-up costs)

-$1,060,000 cost basis (purchase price plus closing costs paid on purchase)

$800,000  capital gain

-$500,000  Section 121 capital gain exclusion ($250,000 if single)

$300,000 Long term taxable gain

Federal tax liability at 20% preferential long term capital gain rate: $60,000

California tax liability at 10.3%*   $30,900  

So after the sale and payment of taxes and expenses, you would have $1,769,100 in hand.

* Note CA does not have a fixed preferential long term capital gain rate as Federal has.  California's tax rate can range upwards from 10.3% on $300,000 of gain to a top rate of 13.3% (with mental health tax on $1,000,000 of taxable income) depending on the taxpayer's other taxable income in the year of sale.  

2.  What if I added a master suite?  Replaced the roof?

These expenses would increase the cost basis in the above example, thereby reducing the net taxable gain and taxes due.

3.  What if I still have a $1 million loan on the property?

This affects after tax "cash-in-hand," but not the amount of tax due: 

$2,000,000 sales proceeds

-$140,000 commissions, staging and fix up costs, other escrow and sales costs

-$90,900 (combination of Federal tax liability $60,000 and State tax liability $30,900)

-$1,000,000 payment of debt

Or $769,100 net spendable cash 

4.  Isn't that a lot of tax, compared to investing $1 million in stocks?

The tax liability (rates) would be the same, assuming that the stock was held for more than one year.  There are fewer costs associated with the purchase and sale of stock, but generally the dollars invested in the purchase of a home are initially only the downpayment.  Mortgage interest is fully deductible on up to $1,100,000 of debt used to purchase and improve the home so long as the debt is secured by a mortgage against the home.  Any debt used to purchase stock is investment interest and is subject to limitations on deductibility. 

5.  Is there a way to avoid paying taxes?  I thought a home sale was tax-free as long as I bought something more expensive?

It was never tax free.  Prior to a tax law enacted in 1997, you could defer (but not escape) the gain on the sale of a residence so long as the purchase price of the new home equaled or exceeded the sales price of the old home.  This law was repealed for sales after May 6, 1997 and the current law taxes the sale of a residence in the year of sale, but added either a $500,000 (if filing jointly) or $250,000 (if single) exclusion to reduce the gain on sale, and thereby reducing the tax. This exclusion, often referred to by the governing Internal Revenue Code section 121, is available for sales of homes that were the taxpayer's principal residence for 2 of the 5 years preceding the sale. See application of this exclusion in computation above at Q&A 1.

Although generally not applicable to the sale of a principal residence, a tax-deferred exchange under Internal Revenue Code Section 1031 provides a way to avoid paying taxes on the sale of property used in a trade or business or held for investment (for instance, rented out), if the proceeds are invested in a replacement property (and other requirements are met).  Although the tax liability on the sale is deferred, the basis of the new property is reduced by the amount of taxable gain on the sale of the old property (which will, among other things, affect the amount of depreciation available on the new property).   

If the new or replacement property is later sold and the taxpayer wishes to "cash out," rather than reinvest in yet another property, the deferred tax will be due, together with the tax on the gain of the new property.

Sometimes, it is possible to combine the 121 exclusion and the 1031 deferral - a personal residence is converted to rental property and then exchanged into other rental property, providing income into the future.  

If that same taxpayer rents out the new property for some period of time (a rule of thumb is 1 year), the taxpayer may then convert the new property back to a principal residence.  The tax advantages of the Section 121 exclusion and the 1031 deferral are preserved so long as the new property met the requirements of investment property.    

7.  What about Proposition 13 Transfers?

Before Proposition 13 passed in 1978, the average property tax rate in California was 3% of assessed value and there was no limit on annual increases. Under Proposition 13, the assessment rate is now only 1% for all California property (although counties are allowed to include additional assessments), and annual tax increases are limited to no more than 2%. 

 

Proposition 60 was passed to allow taxpayers age 55 or older to buy a new home but keep their same property taxes so long as the new home is of equal or lesser value and is located in the same county.  This is a once-in-a-lifetime election.  Proposition 90 was passed to allow for transfers from one county to another (so called "inter-county transfers") if the new county has adopted an ordinance allowing such transfers.   Under certain circumstances this can be a very beneficial tax savings.  However, the counties accepting transfers are limited with currently only 11 out of a total of 58 California counties participating [see this list and info sheet from the state for more info-MK].  

Further, one should carefully consider the value of this step as the savings may not be as significant as they might initially seem, especially where the taxpayer is buying a much less expensive home.  

Thanks Mary!  She can be reached at canning.mary@gmail.com.  

Mary, together with exchange specialist James Callejas of IPX 1031 helped us arrange a 1031-121 exchange when we bought our home on Pacific and 15 months later, after renting it out, sold our home on Pala.  We were able to pull out $500,000 in cash (the Section 121 part), and invest the balance of our sale proceeds in rentals in the area and in Portland.  (We now have two sons in Portland, and could potentially convert one of the rentals there into a pied a terre at some point in the future, converting the condo back into a personal residence.  If we did that and later sold it prior to our deaths (when the estate tax rubric would kick in), there's some complicated tax calculations to be done).

We deferred tax, and could have used the $500,000 as a downpayment on a new home, securing a mortgage for the balance.  Or you could set your sights on Ashland, OR, for instance, buy your retirement home for $500,000 cash, and live mortgage free.

The older of us (that would be me....) wasn't 55 yet, but if I had been, we would be saving about $10,000 a year in property taxes by taking advantage of Prop 60.  Bummer.  But a number of my clients want to sell their $2 million home and buy a $1 million home elsewhere.  In Mary's scenario above, the future tax bill would be about the same either way, so no need to feel limited to 11 California counties if you really want to be in Marin (which is not on the Prop 90 list of cooperating counties).

If you're trying to think creatively about getting from here to there, be sure to work with an agent who knows the process and has a stable of tax, exchange, and property management professionals ready to make it happen for you.  

So go to the plant sale and then take a hike in that great East Bay asset that is Tilden Park!