DEAR BENNY: You recently wrote about the new 3.8 percent tax that can be imposed on home sales. You indicated it would not impact most homeowners who are selling their homes. However, you failed to mention that this tax apparently will be affixed to any and all sales that are not sales of primary residences occupied by the owners for two of the preceding five years. Can you explain? –Larry
DEAR LARRY: That’s not exactly true. The tax is based on income and profit, and even if you have not lived in your house for a long time, you still may not have to pay this tax. Rumors are flying all over the country, claiming that the health reform legislation Congress recently enacted includes a sales tax on all real estate sales. While there is a tax, it does not apply to everyone.
The Health Care and Education Reconciliation Act of 2010 became law on March 30, 2010. It is a comprehensive and extremely complex piece of legislation. One section (1402) is entitled "Unearned Income Medicare Contribution" and does impose a 3.8 percent tax on any profit on the sale of real estate (residential or investment). But it is aimed at high-income consumers, who comprise a small majority of American citizens. And in any event, it does not take effect until Jan. 1, 2013.
Let’s look at the true facts of this new law.
First, it is not a sales tax, nor does it impose any transfer or recordation tax. It is called a "Medicare" tax because the moneys received will be allocated to the Medicare Trust Fund, which is part of the Social Security system.
Next, if your individual income (technically called "adjusted gross income") is less than $200,000, you are home free. The income thresholds are clearly spelled out in the law. If you are married and file a joint tax return with your spouse, the law will apply only if your income is more than $250,000. If you and your spouse opt to file a separate tax return, the threshold is reduced to $125,000. For all other taxpayers, you have to earn more than $200,000 in order to be under the new law.
The up-to-$500,000 exclusion of gain from a home sale for married couples filing a joint tax return (or up to $250,000 for single taxpayers) has not been repealed; also, the right to deduct mortgage interest and real estate tax payment has not been eliminated.
How is the tax calculated? It is a complex formula that could be called "the accountant’s protection act." As a taxpayer, you (or your financial adviser) must determine which is less: the gain you have made on the sale of your house or the amount that your income exceeds the appropriate threshold.
Complicated? Yes. Let’s look at these examples. Your adjusted gross income is $150,000. You sell your house and made a profit of $400,000. There is no change in the way you determine your gain: You take your purchase price, add any major improvements you have made over the years, and subtract that number from the net sales price.
Based on this formula, you and your spouse have owned and lived in the property for at least two out of the five years before it was sold. Accordingly, you are eligible to exclude all of your profit; you are not subject to the new 3.8 percent tax. Keep the money and enjoy.
Change the example so that your adjusted gross income is $300,000. Since you are eligible to take the profit exclusion of up-to-$500,000, once again you do not have to pay the Medicare tax; your entire gain is excluded, and thus there is no profit to tax.
But let’s assume you strike it rich and have made a profit of $600,000. Your income is $300,000. You can exclude only $500,000 under current law, so you will have to pay capital gains tax on the remaining balance. The rate currently is 15 percent, so you will owe Uncle Sam $15,000 ($100,000 multiplied by 15 percent).
But since your income is over the threshold, you now also have to pay the 3.8 percent tax. But on what amount?
As indicated earlier, the tax is based on lesser of your profit or the difference between the threshold and your income. Your profit is $100,000. The difference between your income and the threshold is $50,000 ($300,000 minus $250,000). In our example, the lower number is $50,000, and you will have to pay an additional $1,900 to the Internal Revenue Service (3.8 percent multiplied by $50,000).
According to statistics provided by the National Association of Realtors, in March of this year, for example, half of all existing homes sold for $170,700 or less. Clearly, none of these homes could make a profit of even $250,000, so if you qualify for the exclusion-of-gain requirements you will not be impacted by this new law.
This new law has yet to be analyzed or interpreted. We have more than two years before it takes effect. However, since the law applies to all forms of real estate, including vacation homes, you should consider consulting with your tax and financial advisers as to your exposure.
You will, of course, have to wait until we all have a better understanding how it will work. In the meantime, however, don’t believe the rumors.
DEAR BENNY: We built a vacation home in 1989. We recently discovered that the contractor made some serious errors in construction. Evidently he used poor flashing and waterproofing techniques. We hired another contractor recently to assess the situation. The result was that we had to tear down and rebuild a significant part of the home at great cost.
We contacted the original contractor, who has told us that he has no liability and that the statute of limitations will prevent us from recovering any of our costs from him. Our insurance company says that because the damage was due to contractor error and is long-term damage, it has no responsibility either.
Is the original contractor correct in that he is protected from any action we might take against him? Any other suggestions you might have would be much appreciated.
If I have no way to recover some of the cost from the contractor or the insurance company, do you know if I can at least claim this as a casualty loss when I file my tax returns this year? –Joe
DEAR JOE: Every state has adopted what is known as a "statute of limitations." This means that after a certain number of years you lose your right to file suit. The time limitations may differ on the type of claim — for example, suing for libel may be only one year while suing for breach of contract may be three years.
There is a public policy involved here: If you wait too long before you file suit, it will be difficult to recreate or even remember the facts. In other words, "Use it or lose it." You have to talk to your attorney about the limitations period in your state.
But there is a significant exception, called the "discovery rule." If you suddenly discover a problem that you could not have learned before the statute of limitations expired, you may still be able to file suit. Again, since state laws differ, your attorney should be able to advise you whether you still have the right to file.
Can you claim a casualty loss on your tax returns? Probably not. In order to have such a loss, the event must be sudden, unexpected or unintended. And although your loss may have been unexpected, I doubt that the IRS would accept your claim. For more information, visit www.irs.gov and download IRS Publication 547, entitled "Casualty, Disasters and Theft."
DEAR BENNY: Regarding the repeal of the "stepped-up basis" referred to in your recent column (regarding beneficiaries of inherited homes), would the repeal also apply to a home where the deceased had a life-estate interest in the home? –George
DEAR GEORGE: As you know, this year there is no stepped-up basis. Prior to this year, if the decedent owned a life interest in the property, his life interest expired when he died and there would be nothing to step up. The remainder beneficiaries would not receive any step up based on the death of the life tenant. They received the property with a basis that is the value of the property when the original owner from whom they inherited the property died.
This year (and no one knows what Congress will do about this issue) "step-up" is replaced by "carry-over basis" rules. Oversimplified, this means the basis of inherited property remains the same as it was for the deceased owner. In other words, the basis is the lesser of market value on date of death or the deceased owner’s basis.
However, heirs can increase that basis up to $1.3 million (or up to $3 million for property passing to a surviving spouse) but in no event more than the appraised value on the date of death.
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@example.com.
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