DEAR BOB: My sister-in-law and her husband recently got a legal separation. He wants to keep the house they have shared for more than 20 years because he grew up in that house. The court order says he has to pay my sister-in-law $40,000 for her share of the house within three months. Will she have to pay a capital gains tax on this amount? She doesn’t plan to buy another house but will rent an apartment – Kathy T.
DEAR KATHY: That $40,000 payment to buy out your sister-in-law’s share of the marital home is tax-free for several reasons under federal tax law. Most states have similar conforming tax rules.
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The transfer you describe is a marital title transfer. Such transfers during the marriage, or as part of a divorce or separation, are tax-free under federal law. Incidentally, marital transfers from one spouse to another upon death of a spouse are also tax-free regardless of the amount.
Another reason the $40,000 transfer is tax-free is it would qualify for the Internal Revenue Code 121 principal residence sale tax exemption, up to $250,000 per person (up to $500,000 for a qualified married couple). That’s presuming the seller owned and lived in the principal residence an aggregate 24 of the 60 months before the sale.
Either way, your sister-in-law’s $40,000 marital transfer appears to be tax-free. For full details, she should consult her tax adviser.
TAX-DEFERRED EXCHANGES NOT APPLICABLE TO FOREIGN REALTY
DEAR BOB: I have made several Internal Revenue Code 1031 tax-deferred exchanges. Can I do such an IRC 1031 trade involving the acquisition of a replacement investment property in a foreign country, such as Canada or Mexico? Or can I do an IRC 1031 tax-deferred exchange to purchase shares in a limited liability company (LLC) such as a start-up company doing an independent movie? – Ray S.
DEAR RAY: No and no. Internal Revenue Code 1031 requires the acquired real estate to be located in the United States. Trading for investment property in Canada or Mexico clearly will not qualify.
Neither can you make a tax-deferred exchange of your U.S. investment real estate for shares in an LLC. The reason is that would be an “unlike kind” trade of real property for personal property.
However, the IRS has ruled you can make a tax-deferred exchange of your investment real estate for an interest in a real estate investment tenancy in common (known as a TIC), such as a partial interest in a commercial building with other investors. For full details, please consult a tax adviser who specializes in real estate taxation.
IS A LIFE ESTATE DEED A GOOD IDEA?
DEAR BOB: We have set up our bank accounts, savings accounts, bonds, stocks, and mutual funds to avoid probate by naming our heir in a “transfer upon death” (TOD). But our question is about avoiding probate on the transfer of our biggest asset, our home. We were advised to use a life estate deed so probate would not be needed. Is this a good idea? – Walter M.
DEAR WALTER: A life estate deed is an extremely bad idea to avoid probate. What you would really be doing is transferring the title to your home to your heir now, reserving life estates for yourselves to live in the home as long as you wish.
The reason that is a very bad idea for avoiding probate is your plans might change. Or your heir might die before you do, thus making your life estate home included his or her estate.
Equally important, suppose you need to sell your home to provide cash for investments, medical care or moving to another area. In other words, a life estate deed gives up control, something you don’t want to do.
A far better alternative is to transfer title to your home into your revocable living trust. You control the living trust. If you wish, you can sell or refinance the living trust assets, such as your home. When the second spouse dies, then the house would go without probate to whomever is named in the living trust.
The living trust can be easily amended as often as you wish, such as to disinherit your heir. More details are in my special report, “Living Trust Pros and Cons for Avoiding Probate Costs and Delays for Your Heirs,” available for $4 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet download at www.bobbruss.com. Questions for this column are welcome at either address.
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