Some recently widowed homeowners who realize profits on sales of their principal residences will benefit from legislation enacted on Dec. 20, 2007, and known officially as the Mortgage Forgiveness Debt Relief Act of 2007. The legislation liberalizes rules already on the books that allow sellers to "exclude"--that is, avoid taxes on--some, and perhaps all, of their capital gains.
The existing rules, introduced in 1997, excluded from taxes profits of as much as $500,000 for married couples who file joint returns and $250,000 for those who file single returns or married couples who file separately. Remember--the exclusion refers to the profits, not the sales price--and those $500,000 and $250,000 amounts are caps on the exclusion. Profits above the caps are taxed at a maximum rate of 15 percent on long-term capital gains, plus applicable state and local income taxes that can be claimed as itemized deductions on Schedule A of Form 1040.
On the plus side, that profit exclusion is not a one-time opportunity. Sellers may claim the $500,000 or $250,000 exclusion each time they sell their principal residence, but generally not more frequently than once every two years.
One admonition: The full exclusion is available only for sellers who meet two simple tests. First, they must have owned and lived in the property as their principal residence for periods that aggregate to at least two years out of the five-year period that ends on the date of sale. Second, they have not excluded gain on another sale of a principal residence within the two years that precede the sale date.
The IRS allows sellers to meet the ownership and use tests during different two-year periods. These periods do not have to overlap or be continuous. However, the IRS is unyielding on its requirement that the seller meets both tests during the five-year period ending on the date of the sale. But the agency does not insist that the property be used as a principal residence at the time of its sale. An example: Someone who occupies a home for the first and fourth years during the five-year period nonetheless qualifies for the exclusion.
Recently widowed spouses should familiarize themselves with liberalized rules that grant them more time to sell and still qualify for the $500,000 joint-filer exclusion. This break for surviving spouses took effect at the start of 2008. To illustrate the changes, let's apply the rules to widow Mabel and her deceased husband, Mack.
The pre-2008 rules allowed Mabel to exclude up to $500,000 only if she completed the sale of their dwelling not later than the end of the year of Mack's death, and she filed a joint return for that year. (When one spouse dies during the year, the other can still file a joint return for the year. This is an exception to the standard rule that marital status for the entire year is determined by status on Dec. 31.)
Contrast "Mack A," who is considerate enough to die on Jan. 2--thereby giving Mabel until Dec. 31 to sell and exclude $500,000--with "Mack B," who dies on Dec. 29, giving Mabel all of two days to sell and exclude $500,000. A Mabel who is unable to meet the end-of-year deadline gets to exclude no more than $250,000--the limit for a single taxpayer. An additional gain of $250,000 taxed at a top rate of 15 percent adds $37,500 to her tax tab. Should she run afoul of the AMT, she can add to that any nondeductible state and local taxes.
For 2008 and subsequent years (assuming Mabel has not remarried as of the date of the sale), she qualifies for the $500,000 exclusion if she sells within two years of Mack's death. But what if a moribund market causes her to miss the deadline? The old rules cap her exclusion at $250,000.
Whether Mabel passes or flunks the deadline, IRS code section1014 authorizes an exceptional condolence gift for inheritors of appreciated property. Even without the up to $500,000 exclusion, Mabel sidesteps capital gains taxes on part or all of the gain that built up while Mack was alive. On Mack's death, their home's basis is "stepped-up" from its adjusted basis (usually, original cost plus improvements) to its value on the date of death. (In certain cases, an estate's executor has the option to use the property's value six months after the date of death.)
The step-up covers at least Mack's one-half interest, assuming the couple held the property in joint ownership with the right of survivorship. There is no step-up for Mabel's one-half interest. Mabel and other heirs benefit from forgiveness of capital gains taxes on part or all of pre-inheritance appreciation and, on subsequent sales, tax liability only on post-inheritance appreciation. This can translate into considerable tax savings.
For example, Mack and Mabel bought their first home for $250,000. They made improvements that cost $50,000, increasing their jointly owned home's adjusted basis to $300,000. When Mack dies, the home is worth $1,000,000. His one-half interest is stepped-up from $150,000 to $500,000. Mabel's share of the adjusted basis continues to be her original $150,000. So her stepped-up basis becomes $650,000-- $500,000 plus $150,000.
Let'sassume that Mabel does not remarry, and her home continues to appreciate. She subsequently sells her home for $1,750,000, resulting in a gain of $1,100,000--the excess of the sales price of $1,750,000 over her stepped-up basis of $650,000. A sale within two years of Mack's death means Mabel excludes $500,000 of the gain and owes capital gains taxes on the remaining $600,000. But should she miss the two-year deadline, only $250,000 of the gain is excluded, and she owes taxes on the remaining $850,000.
The joint ownership rules do not apply in the community property states--Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In those states, there usually is a step-up in basis for all of their community property. If at least one half was included in Mack's estate, then Mabel is considered to have acquired her share (the part not included in his estate) by inheritance. As of Mack's death, there is a step-up in basis for both his and her interests.
A major uncertainty, however, is that the step-up in basis is mired in a legislative limbo. Beginning in 2010 (in conjunction with the scheduled elimination of the estate tax), the law imposes a ceiling on the amount of property eligible for a stepped-up basis. This restriction allows an estate to increase the basis of assets by no more than $1.3 million. It also allows a surviving spouse who receives assets from an estate an extra basis step-up of as much as $3 million.
Assuming there is no extension of the estate tax repeal, the current stepped-up basis rules again take effect in 2011. But the cap on the step--up might be further revised or even undone between now and then. Stay tuned.
Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books can be found at www.julianblocktaxexpert.com.