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Capital Pains
By Karen Hube, November & December 2005
Her retirement income is tied up in her home. Can she sell without owing a bundle to Uncle Sam?
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The only thing between Carolyn Reis, 58, and her retirement is a big fat tax bill. Reis, a widowed nurse in New Rochelle, New York, doesn't have a lot of money saved for retirement, but she has always figured she could sell her biggest asset her home buy a less expensive condo, and live off the difference. Indeed, the hot New York real estate market has been a boon to folks like Reis: she bought her home in 1965 for $15,000, and it's now worth about $500,000.
The Problem
What she didn't figure, though, is that the Internal Revenue Service would siphon off a big chunk of that gain. Under tax rules, just $250,000 of capital gains from a primary residence is exempt from taxes for singles (the number rises to $500,000 for couples). The way Reis figures it, she'd have to hand over $35,250 to Uncle Sam (the $485,000 gain minus the $250,000 exemption leaves $235,000 subject to a 15 percent long-term capital gains tax rate). She'd like to sell her home soon, but she wants to find out first how she might mitigate the tax bite.
The Plan
It's a good thing that Reis doesn't simply plan to ante up the tax. There are a number of perfectly legitimate strategies that may dramatically reduce her tax bill.
First, she should take advantage of a tax rule that benefits widowed spouses by stepping up the cost basis, which is the value of an asset used for determining capital gains. In most states the surviving spouse can figure cost basis as half the original cost of the home plus half the value at the time of the spouse's death, which in Reis's case was $350,000. So while Reis has always figured her cost basis was the $15,000 purchase price, under the widowed spouse rule, it's actually $182,500 ($7,500 plus $175,000), and her taxable gain would be $67,500 ($500,000 minus $250,000 minus $182,500). That would leave her with a tax bill of $10,125.
But Reis can further whittle down the tax by adding the closing costs from the original purchase and the cost of certain home improvements. Over the years Reis and her husband upgraded two bathrooms, renovated the kitchen, installed new hardwood floors, and put in central air conditioning. The cost of those improvements can be added to the $15,000. "You can't count routine repair and maintenance jobs like painting and fixing leaks," says Christopher Loiacono, cochair of the tax department at Eisner LLP in New York City. "But you can count anything that adds to the long-term utility of the property." The hitch: "You must have receipts and proof of payment," says Loiacono.
Reis figures she can account for about $50,000 of upgrades and closing costs, all of which were completed before her husband's death. So that would bump up her original $15,000 cost basis to $65,000 and further knock her tax bill down to $6,375.
There's one more way to slash gains. Tax rules let you offset investment gains with losses which means a gain in the value of her property could be reduced by a loss in her stock portfolio.
So before signing a check to the IRS, Reis must start sifting through her portfolio for losers. Chances are, she'll be able to squash even more of the tax and get on with her life.
Karen Hube is a financial writer in Westport, Connecticut.
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