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Chris Jones

One of the primary goals of estate planning is to minimize the costs associated with wealth transfer, including court costs and taxes. While most people associate estate taxes with estate planning, we must also consider how to minimize or avoid both property and income taxes. Proper planning makes more of your assets available for your care during your lifetime, and for your beneficiaries at your death.

Capital gains tax is a type of income tax that are owed for the gains (profits) realized in a sale of property, such as real estate. This tax applies to the gain on all real property, including your house. The gain is computed by subtracting from the net sales price what was paid for the property and any capital improvements.  For example, if a couple paid $30,000.00 for a home in 1970 and sold it today for $1,000,000.00, their gain before costs of sale is $970,000.00.  Between the federal and state governments, this gain is taxed at a total of 23%, or in this case, $223,100.00.  The tax for capital gains is due for the year in which the sale takes place.  Since real estate in California has greatly appreciated over the past decade, and since real estate has become the major asset for most families, part of the estate planning process is to minimize or eliminate this tax. This article is intended to discuss strategies to achieve that goal.

Capital gain is not recognized if you exchange, as opposed to sell, properties of “like-kind.”  This exemption applies only to property held for the production of income, such as rental property, securities, or corporations.  For purposes this type of exchange, all real property, improved and unimproved, is considered of like-kind.  For example, it is possible to exchange an interest as a tenant-in-common in real property for unimproved land. The key is whether the real property is held for the production of income.

This strategy allows taxpayers with profitable real estate investments to swap them for other real estate investments without paying the capital gains tax.  If the taxpayer repeats this process throughout their lifetime, and still owns the exchanged-for real estate at their death, the gain will never be taxed.  This is because the rules re-establish the taxpayer’s “basis” in the property to its fair market value as of the date of the taxpayer’s death.  One of the advantages of transferring property at death is that the property gets a new valuation for purposes of capital gains taxes.  Typically, this results in an estate or the estate’s beneficiaries being able to sell appreciated assets at a price for which neither the estate nor beneficiaries will have any capital gains tax obligations.

The capital gain on the sale or exchange of a principal residence is excluded up to $250,000.00 for a single person, and up to $500,000.00 for a husband and wife.  In order to take advantage of this exemption from capital gains taxes, the taxpayers must demonstrate that they both owned the property for at least 2 of the 5 years preceding the date of sale, and that they used the property as their principal residence for at least 2 of the 5 years preceding the date of sale.  Finally, the taxpayer must show that they have not made any other sale to which the exemption applied during the 2-year period preceding the date of this sale.  The 2-year ownership and use requirements do not have to be concurrent, nor does the 2 years have to be one continuous period.

If a taxpayer owns real estate income property that was acquired through a like-kind exchange, it may be converted to his or her principal residence and take advantage of the same deductions.  However, he or she must have owned and resided in that residence for a period of 5 years before taking the deduction.

If a taxpayer becomes incapable of taking care of him or herself and moves out of his or her residence into a licensed care facility, he or she needs only to own and use the home as his or her principal residence for at least one year during the five-year period preceding the sale.  The time he or she spends in the facility can be added to the time of actual use of the house to satisfy the 2-year use requirement.

Many of my clients have used this strategy by converting what had been income producing real property to their  principal residence. By living in the property for two years before selling it, they can save approximately $115,000 in taxes that would have been owed on the gain. This is like being paid $57,000 per year for doing nothing more than living in your own property!

As mentioned above, all assets owned by a decedent at the time of death acquire a new basis equal to the fair market value as of that date.  This increase in basis is a useful feature in estate planning.  It often allows for an estate to escape any capital gains taxes by providing that assets be transferred at the time of death rather than during a taxpayer’s lifetime.  In contrast, any gifts made during lifetime, such as adding other owners as joint tenants, do not increase the basis of that property at death. When the survivors sell the property, they owe the same capital gains tax that the original owner would have paid. While such a technique may avoid probate proceedings, it creates a large tax liability that could have been easily avoided by proper planning.

Because of the potential for extremely high capital gains taxes on a home that has been held for many years, it may be advantageous for a taxpayer to either rent the home or borrow money against it rather than sell it so as to pay for their on-going care.  By providing that the home transfers at death, both the taxpayer and their estate will avoid any capital gains taxes.

For people with assets that have appreciated, capital gains taxes may be the single largest expense faced by their estate.  Proper planning can, in many cases, reduce or eliminate this tax. Make the effort now and you will be rewarded over your lifetime, and you will best provide for your beneficiaries.

- The Estate Planning Team
Rogers Sheffield & Campbell, LLP

This article is not intended to provide legal advice. For legal advice on any of the information in this post, please contact one of our attorneys directly, use the form to the right or contact us by phone at 805-963-9721.

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