24 June 2017
My cultural reference du jour is a nod to Ms. Meghan Trainor’s very catchy 2014 tune about her backside. Whilst I have always been appreciative of such assets, this article is about appreciating assets of an entirely different nature. We are talking about assets that increase in value (specifically houses), making them taxable, and how you might mitigate or avoid paying the taxes on them altogether.
The first thing we need to do (after we stop with the 'basis' and 'assets' puns) is make sure we are all speaking the same language. I’m going to throw some words around and I want to make sure you know what I mean when I use them. I looked at the dictionary definitions, but I decided to explain these terms in my own words.
Appreciate – In this context appreciate means increase in value. If I say I have an appreciated asset that means I have an asset that is worth more now than when I acquired it.
Asset – that’s a thing I own that has monetary value. My house is an asset. My truck is an asset. My stock and bond funds are assets.
Basis – This is the dollar amount of your investment in the asset. This is often the purchase price of the asset – but not always. Sometimes things happen that adjust (change) your basis in the asset. (This can be confusing and it’s the reason I am writing this article.)
Capital Gain – When you sell an asset for more than you paid for it you have a capital gain.
Capital Gain Taxes - When I sell an asset that has appreciated I have a capital gain. Generally speaking, capital gains are considered income and are subject to income taxes. The tax rate on capital gains depends on the type of asset you own and the length of time you have owned it.
Depreciate – In this context depreciate means to decrease in value. It is the opposite of appreciate.
Fair Market Value (FMV) – The current value of the asset on the open market.
Tax Basis (or Taxable Basis) – This is your investment in the asset for tax purposes. This can be confusing because at times it appears to have nothing to do with the actual amount of your investment or the value of the asset.
Taxable Gain – Generally speaking, taxable gain is (Sale Price – Tax Basis)
Step-up in Basis – When someone dies all their assets are transferred to (inherited by) beneficiaries. The beneficiary’s basis in the inherited asset is the fair market value of the asset on the date the previous owner died. If the asset appreciated since it was acquired by the previous owner, then the beneficiary receives a “step-up in basis”.
Let’s Focus on Residential Real Property (like houses and condos).
As an asset class houses are large and complex. People tend to own them for long periods compared to other asset classes. They also do things with them that can change the tax basis of the asset. If a house owner improves the house (by, say, adding an additional room) s/he can increase their tax basis in the property. If the house owner uses the house in a business s/he can take a business expense for depreciating the property and lower their tax basis in the property.
While far from universal, houses tend to appreciate over time. Selling them generates a capital gain for the homeowner. Fortunately, Congress decided to give us a tax break on our homes. Capital gains up to $250,000 for single filers and $500,000 for couples filing jointly are excludable under section 121 of the tax code if the house is used as a primary residence.
Let’s look at a scenario in which these tax concepts come into play:
John and Mary purchased their house in 1971 for $80,000, and have lived in it ever since (original basis $80,000). They raised their 3 children in that house. In 1992 they spent $20,000 to add a mother-in-law suite so Mary’s elderly mother could move in with them. (Their adjusted basis is now $100,000 because they spent $20,000 to improve the property.)
Mary’s mother passed in 1998. John and Mary paid off the mortgage to the house in 2001 and now own it free and clear. By 2017 John and Mary are elderly and could use some assistance. Their house is now their most valuable asset, valued at $380,000. John and Mary want to stay in their house and would like their daughter Debbie to come over every day to help care for them. To entice Debbie they offer to transfer the house to her name.
THIS WOULD BE A HUGE MISTAKE!
There is a significant tax difference between transferring assets while you are alive and transferring them when you are dead. John and Mary’s tax basis in the house is $100,000. If they transfer the house to Debbie while they are still living, John and Mary’s tax basis transfers to Debbie. This house IS NOT Debbie’s primary residence. When she sells it she will have to pay taxes on any capital gain from the sale. If she were to sell the house for $380,000, her taxable gain would be $280,000. Even at the best capital gains tax rate, Debbie may owe somewhere in the neighborhood of $42,000 in taxes from the sale of the house.
If John and Mary want Debbie to receive the greatest possible financial benefit from the house they should keep it in their names and make sure it transfers to Debbie when they both pass. If they do that, when Debbie inherits the property she receives a step-up in basis to the FMV of the property as of the date of the last remaining parent’s death. Let’s assume this was still $380,000. If Mary has a tax basis of $380,000 and sells the property for $380,000, then she has no capital gain (and therefore owes no tax on the sale).
Let's continue with this scenario...
It’s 2020 and the house has appreciated to be worth $400,000. John and Mary have both passed and Debbie inherits the house with a step-up in basis to $400,000. Debbie sells the house to Paul for $400,000. Paul immediately places the house into service as a rental property. The county tax assessor has indicated that the value of the property is based on the land being worth $125,000 and the house being worth $275,000. Because the property is now being used in a business it can be depreciated for tax purposes. Per the Internal Revenue Code land does not depreciate, therefore the depreciable basis for the property is Paul’s basis in the building - $275,000.
For tax purposes residential real estate depreciates linearly over 27.5 years. Therefore, Paul is entitled to claim a $10,000 depreciation expense deduction for this rental property each year. Paul owns the rental property for 10 years and then decides to sell it. He never made any other capital improvements to the property.
Over the 10 years he has owned it Paul has taken a total of $100,000 of depreciation expense on this property. When he sells it he must adjust his basis in the property to reflect this depreciation deduction. His original basis was $400,000. With $100,000 of depreciation adjustments his adjusted basis is now $300,000.
Paul sells the property for $500,000. Paul has $200,000 of gains, but he actually has 2 different types of gains. The first $100,000 is essentially recapturing the depreciation expense. This is (confusingly) known as “unrecaptured section 1250 gain”. The second $100,000 of gain is a capital gain, and is taxed at the capital gains rate. (Paul never lived in this house, so he does not qualify for the section 121 exclusion.)
If you’ve read this far and your head hurts, you’re probably going to hate what I am about to say next. I have kept these examples very simplistic to highlight some of the concepts used in adjusting basis. I wanted to keep the math easy. In reality, there are several additional factors (such as selling/buying costs) that would need to be considered when figuring the adjusted basis on a house.
These can be difficult concepts, but they are also very important. The value of a house is typically significant relative to the total of a person’s assets. House sales can also have significant tax implications, so you want to make sure the basis is correctly calculated and you are paying the correct tax bill each year. As always, if you have questions, call me.