How You Own Your Home Can Save You Taxes

Estate Planner Nov-Dec 1998

Last year Congress changed the rules for taxing the gain resulting from the sale of a principal residence. These new tax rules may have a significant effect on the way you structure the ownership of your family residence for estate planning purposes.

The Changes

Under the Taxpayer Relief Act of 1997, eligible married taxpayers filing jointly may now exclude up to $500,000 ($250,000 for a single taxpayer or a married taxpayer filing separately) of such gain. This exclusion is available once every two years and replaces:

  • The one-time $125,000 exclusion from capital gain for a homeowner age 55 or older; and
  • The tax free rollover available to any homeowner who acquired a more expensive replacement home within two years of the sale of a principal residence. 

Step-Up in Basis

If you do not expect the appreciation in your family home to exceed $250,000, you will no longer need to put ownership in the name of the spouse who is most likely to die first. Why? Because you no longer need the step-up in basis available at death for assets included in the deceased’s gross estate to avoid capital gains tax when the home is sold.

If the appreciation in the family home will approach $500,000, consider joint ownership with your spouse, either through joint tenancy, community property (if available), tenancy by the entirety or tenancy in common. In such instances, one half the value of the residence will be included in the estate of the first spouse to die. It will receive a step up in basis, and the surviving spouse will have a $250,000 exclusion from gain on his or her one half interest in the residence. Therefore, you will eliminate or minimize capital gain on the sale.

Sale of Second Residence

The exclusion from capital gain only applies to the sale of a residence that has been your principal residence for at least two years. Accordingly, if you are considering selling your vacation home and it has appreciated substantially, deferring the sale for two years and taking steps to make the vacation home your principal residence may be tax advantageous.

Changing your principal residence is not necessarily easy or wise, however. Depending on a number of circumstances, you may need to completely change your domicile to a new state. Or you may need only to spend more time in the second home than in the first home for two years to make the vacation home your principal residence.

You may have intentionally changed your state of domicile to take advantage of favorable income tax treatment (Florida and Nevada, among others, have no state income tax) or to escape state imposed gift, inheritance or generation-skipping transfer taxes, but maintain a residence in your former state as well. Neither residence is considered a vacation home, but make an effort to show that the residence in the new domicile is the principal residence. When it comes time to sell the residence in the former state, however, you will owe capital gains tax on the appreciation.

The capital gain exclusions under the new tax law will not apply if you are not selling a principal residence. You may want to consider “moving” back to the old domicile for two years prior to a sale to re-establish that home as your principal residence. The benefit could be a savings of up to $100,000 ($500,000 gain exclusion times 20% tax rate). A disadvantage is that for two years you might be exposing yourself to the tax system you sought to escape. After the sale and tax savings, you can reestablish residency in the tax advantaged state. Keep in mind that after two years in the new principal residence, the exclusion from capital gain is again available.

The inconvenience and cost involved in changing a secondary residence to a principal residence may override the potential capital gains tax savings. Yet, if you are likely to sell or dispose of a residence in the near future, it may be worthwhile to consider the ramifications of a change.

Qualified Personal Residence Trusts

A gift of a remainder interest (effective after a term of years) in a vacation residence is a popular technique to leverage a gift to children for estate planning purposes. This type of gift uses a qualified personal residence trust (QPRT) or a residential grantor retained income trust (ResGRIT). You place the residence in trust and reserve the right to occupy it for a set period. At the end of the term, the residence is owned by the remainder beneficiaries (such as your children or a trust for their benefit) and you either become a rent-paying tenant or vacate the property.

One QPRT disadvantage is that the remainder beneficiaries inherit your basis in the property and will pay a capital gains tax on its subsequent sale. But if, prior to the sale, ownership of the residence vests in one (or more) of your children who is able to maintain the property for two years as a principal residence, then up to $100,000 in capital gains tax savings may be realized.