Hopefully, you are not panic-selling to move: California has awesome people, climate, entertainment, educational opportunities and business. For property taxes, see my “Local Tax Impact in Santa Cruz County.”
IRS Capital Gains rates run 15% for couples making over $89,251 and 20% for those earning over $553,850. IRMAA Medicare surcharges and the 3.9% Obamatax kick in from temporarily high income. A total of 62.2% of Californians face down ruthlessly ordinary CA taxation up to 13.3% on house sales. Homeowners could lose over 30% of a sale with $300,000 of gains and pay $100,000 of taxes. Home dwellers and landlords seek divergent relief strategies.
Home Dweller Relief
Surely the IRS is not out to punish “accidental luxury owners” ready to step down their housing? IRC Sec 121 (California conforms) relieves single homeowners $250,000 gains and couples $500,000 provided that they owned and lived in the house for two out of five years. Proportionate savings come when you supply non-tax reasons to move: Job changes, divorce, natural disaster or military service.
Business In Your House?
But imagine that you took $50,000 depreciation deductions for a room rental or home office sometime—and the IRS has a very good digital memory. Then you join landlords who have to pay back ordinary income tax of $50,000 upon sale for depreciation recapture. If you flip houses, you must be able to demonstrate non-venial living intentions lest housing become fully-taxable inventory for sale.
The Landlord’s Tax Dilemma
Some landlords grow sick of caring for long-term property; 1031 exchanges let them delay capital gains by trading property. Landlords juggle capital gains forward to other houses of equal or greater value. They can’t trade American real property for foreign real property but can trade a house for a commercial property, like a Nevada gas station or the surrounding desert land. Exchanges trade in old loans for new, so they are far less popular with today’s higher interest rates.
Sec 1031 establishes elaborate rules that entrap unwary sellers with unwanted gains taxes. Cash received from cheaper properties or loans paid down are both taxable “boot.” Rarely can landlords find the precise property to trade at the precise time, so the IRS generously allows just 45 days to identify three properties and 180 days to close. Sellers cannot touch the money, so they must work with exchange companies whose bookkeeping verifies taxable transactions. Reverse exchanges let taxpayers buy replacement property first, then try to sell properties in the same time window. Some landlords retire completely with 1031 exchanges into Delaware Trusts with fractional property ownership that can later be made marketable REITs.
Adding Up the Gains
Homeowners and landlords should begin record keeping with the Settlement statement for purchase because it lists reductions to basis like notary fees, title insurance and appraisals. Ignore loans, HOA fees, utilities and property taxes deductible elsewhere to landlords. Homeowners can’t take landlord depreciation, but they can track improvements, like a new bathroom or a concrete driveway. Often owners improve property just before sale hoping improvements pay off—and this adds to basis. Landlords can’t deduct section 121, but both types of owners look at the settlement statement for deductions from sales costs: e.g. realtor’s fees, transfer taxes and title company fees.
Realty capital gains = contract sales price – selling costs – home improvements – section 121 exclusions (for home dwellers) – purchase costs.
Cash in pocket = sales price minus loan principal and other expenses, minus taxes (capital gains, Medicare, CA income) and additional IRMAA.
Capital Gains and Housing Affordability
Do capital gains keep Californians from moving? Realtor.com estimates that 34% of homeowners exceed the single filer exclusion. “By 2030, that share is projected to reach 56%, turning what used to be a niche tax issue into a widespread drag on housing mobility, and, by extension, supply.” Democrat Jimmy Panetta and Republican Ted Cruz both seek lower capital gains indexed to inflation to “increase the supply of homes available to young families ….” Reverse mortgages purchase or preserve, so they don’t cause housing shortages. And the step-up in basis at death is the best tax dodge: The wealthy avoid gains taxes indefinitely if succeeding generations stay put.
Or government can just tax the rich for nationalized housing to provide homes for all?
Robert Arne, EA, CFP, MS, of Carpe Diem Financial Life Planning, gives holistic financial advice as his client’s fee-only fiduciary. He serves mostly Santa Cruz Mountain dwellers. These articles must not be read as personal financial, mortgage, tax or investment advice; consult appropriate professionals. Learn more at www.carpediem.financial.
