DEAR BENNY: I am a 90-year-old widower. I will have to sell my house when I am no longer able to drive. My problem concerns the possible tax on my profit. I possibly will get double my cost of 20 years ago but the dollars have lost half of their value (purchasing power) so there may be no gain at all. I call this “imaginary profit.”
I understand that in the past there was no tax for elderly people when they sold their house at a gain. Is there such a law presently in existence? –Charles
DEAR CHARLES: Some people call it “imaginary profit” while others call it “phantom income.” Either way, you have made a profit and must pay the applicable tax.
I am not aware of any federal law that would allow elderly people in general to avoid having to pay the capital gains tax. The state in which you live may have some kind of benefit and you should raise this question with the appropriate state government tax and revenue department.
However, there are some federal tax breaks depending on your income. The maximum capital gains tax is 15 percent of the net gain. However, if you are in the 10 or 15 percent tax bracket, you pay only 5 percent tax on your gain.
Let’s take this example: You bought the property for $50,000, made no improvements, and can sell it for $400,000. That is a profit to you of $350,000 (I am not taking into consideration closing costs or real estate commissions). If you have owned and use the property for two out of the five years before it is sold, you can exclude the first $250,000 of gain.
But what about the additional $100,000? Assuming that you have no other income, the first $31,850 would be taxed at 5 percent and the balance of $68,150 at 15 percent.
Starting Jan. 1, 2008, lower-income persons will not have to pay any tax on the amount that is exempt under the new tax rules. So in our example, if you sell next year, you will have to pay only 15 percent tax on the $68,150.
In order to reduce your tax consequences, make sure that you include all of the closing costs associated with both the purchase and the sale of your home. Homeowners should keep their settlement statements (called HUD-1) forever or at least six years after the last transaction takes place.
DEAR BENNY: In a number of columns over the past few years, people have written about condominium associations implementing monthly renter fees. Recently my condo association has been thinking of doing the same. I am currently an off-site landlord.
Can the board of directors implement such a fee? –Bob
DEAR BOB: One of the basic rules on condominium living is that common expenses are to be paid by unit owners based on their percentage interest. These percentages can usually be found in the declaration, which is a legal document creating the condo association. This document is recorded among the land records in the state where the property is located.
Accordingly, if the board wants to impose a renter fee, the burden is on the board to justify its decision. Does a renter cost the association more than an owner? Many associations can legitimately charge a move-in, move-out fee, but this fee is levied across the board and is a charge whether a tenant or a new owner moves in or out of the complex.
It is true that when a person buys into a condominium, he or she is bound by the rules and regulations (and legal documents) as they currently exist and as they may be properly amended from time to time.
Condominium associations throughout this country have attempted to limit — or even restrict — owners from renting out their units. Where these issues have been litigated, the majority of the courts have upheld these restrictions, but only where the legal documents have been properly amended. As you know, in order to amend your declaration or bylaws, it requires a super-majority of all owners (often 66.6 percent or even 75 percent) to vote in favor of the proposal.
But many courts have invalidated resolutions merely enacted by the board, where membership approval was not obtained.
I personally question whether such a resolution in your community would be valid. From a practical point of view, how will the board monitor who is renting and who is not? This could create a serious burden on the association and not be cost-beneficial.
It is obvious that your board wants to restrict rentals in your building. They should address the issue head-on, and try to get the membership to enact a valid by-law or declaration amendment. But to selectively target owners who rent by imposing a “rental fee” seems discriminatory to me.
DEAR BENNY: Bob Bruss frequently mentioned the benefits of the Starker exchange. Would you look at the negatives so I can have a balanced understanding of the issues? –Ward
DEAR WARD: The U.S. Treasury Inspector General for Tax Administration (TIGTA) recently reported that for year 2004, some 338,500 Form 8824s were filed by the IRS. This is the form that taxpayers who do a 1031 (Starker) exchange must file with their annual income tax return.
Obviously, a lot of people were taking advantage of this tax benefit for investors.
But you are correct: 1031 exchanges are not for everyone, and here are some of the negative aspects.
First, before anyone does an exchange, they should talk to their accountant. Perhaps you have other losses that can be used to offset the gain you are trying to shelter? You also may not have enough gain to merit doing the exchange. I am often approached by clients who want assistance with an exchange, but when we analyze their situation, they may have to pay only $5,000 to $10,000 in tax. In those cases, it is just not worth going through the complex legal requirements of a 1031 exchange.
Second, when you sell the relinquished property, there are two specific time limitations: You must identify one or more replacement properties within 45 days and actually close by the earlier of 180 days after the sale or the due date — including extensions — of your federal income tax return for the year in which the sale occurs. (Note: The IRS safe harbor is that you can identify up to three replacement properties.) It is not always easy to locate good investment properties within that short period of time, and this time limit is carved in legislative stone.
Incidentally, I just read that the IRS is currently reviewing whether they have the authority to extend the time in which to take title to the replacement property in situations where the intermediary holding the escrowed funds is in bankruptcy.
Third, there are costs associated with the exchange. You have to pay the fees for the intermediary/escrow agent who will hold the sales proceeds of the relinquished property. You will have to pay closing (escrow) costs to obtain the replacement property, and you will spend a lot of time and effort looking for those replacement properties.
Fourth, the basis of the relinquished property becomes the basis of the replacement property. When you ultimately sell the new property, unless you do yet another 1031 exchange (or die), you will have to pay all of the capital gains that you deferred by doing the exchange. Many people call this a “tax-free” exchange; it is not. It is only a tax-deferred exchange.
Finally, do you want to be a landlord again? That’s a personal decision that only you can make, but you must keep the replacement property as an investment for at least two years.
Now that you have the pros and cons, you should be able to make an educated decision.
DEAR BENNY: My father cosigned the loan to assist me in purchasing my townhome a number of years ago, although I have made all the payments. I don’t remember if his name is on the title. If he should die before I sell, would this put me in a bind? What is the best way to remove his name? –Beth
DEAR BETH: You should either go to the local recorder of deeds office in the county where your townhome is located or ask an attorney to do a title search. That will tell you if your father is on title with you.
Also, many states now have excellent Web sites where you can determine the status of your title.
If your father is on the title with you, it is a simple matter of having him sign a deed over to you, which must be recorded among the land records.
But, before you do this, you must consult a financial advisor (or an attorney) to determine if this is really the way you want to go. There may be significant tax implications from such a transfer. For example, let’s say you bought the property for $100,000 and your father owns half of it. Let’s further assume that the property is now worth $400,000. Your father’s basis for tax purposes in the property is $50,000. If he gives his half to you, you will pick up his basis, so (unless you have made improvements to the property) your basis will be $100,000 (your basis plus his). The basis of the person receiving a gift is the basis of the donor.
If your father is on title, you have to determine how title is held. If it’s held as joint tenants with rights of survivorship, then on his death you will automatically own the entire house. On the other hand, if title is held as “tenants in common,” then on his death his half will have to go through probate. For all you know, he may have wanted to protect your siblings so that on his death they would inherit a piece of the property.
Should your father die when the property is worth $400,000 and title is held jointly, you will get the benefit of what is known as the “stepped-up” basis. In other words, the value of the property on the date of death is transferred to you. So instead of having a tax basis of only $100,000, your basis would be $250,000 (your $50,000 plus $200,000).
This may be significant when you go to sell the property. The higher the basis, the less gain and thus the less capital gains tax you will have to pay.
And even if you are eligible for the up-to-$250,000 exclusion of gain, if your basis is $100,000 and you sell the property for $400,000, you will still have to pay tax on the $50,000 above the exclusion limits.
Please don’t do anything until you have discussed all issues with your independent advisors.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to [email protected].