It s not an issue that evokes much sympathy from fellow taxpayers. But it s a growing problem nonetheless: Unprecedented levels of home equity appreciation during the last decade have pushed a rapidly swelling number of homeowners beyond the $250,000 and $500,000 tax-free limits on real estate gains.
Boo-hoo, you say? That s understandable if you re nowhere near bumping into those limits or you re tired of hearing about billowing federal budget deficits. But new research from Harvard University and reports from the front lines by prominent tax lawyers and financial advisors suggest that the current congressional capital gains ceilings are being outrun by real estate inflation.
The Harvard research, from the Joint Center for Housing Studies, found that as many as 850,000 American homes may now be valued at $1 million or more. Far more are valued at $500,000 and up. Most of these homes, in turn, are in areas that have experienced sustained high appreciation rates since the mid-1990s.
As a result, it s not just in cities like New York where million-dollar homes represent significant percentages of the total housing stock. In Harvard s hometown of Cambridge, Mass., for example, one of every nine homes is worth $1 million or more. San Francisco, the District of Columbia, Los Angeles, Boston, and Fort Lauderdale, Fla., all have large numbers of million-dollar-plus houses. And California boasts sprawling geographic swaths where a $500,000 home is not only unremarkable but below average. In California s highest-cost communities, $1 million is the entry-level cost for a fixer-upper or a tear-down.
Such widespread high prices, plus 200 percent to 400 percent underlying equity gains for many owners, were nowhere in sight when Congress streamlined the home real estate taxation rules in 1997. A key purpose of the reforms, said Capitol Hill proponents at the time, was to eliminate federal taxes for virtually all home sales except those of the super-rich.
Yet today, even middle-income longtime homeowners in large areas of the country find their gains far outstripping the $250,000 (single filer) and $500,000 (married joint filer) tax-free exclusion limits.
Gerald J. Robinson, a real estate tax lawyer in New York, said, “It s really a very commonplace problem. People who never thought they could possibly [exceed the limits] now find themselves owing money” to the IRS when they sell their homes. His new book, J.K. Lasser s Homeowner s Tax Breaks, includes a chapter on how owners can reduce or avoid capital gains taxes when they exceed the ceilings.
For starters, Robinson notes that far larger numbers of taxpayers probably exceed the limit than realize it, especially baby boomers and others who ve owned and sold several houses over the last 20 to 30 years.
Robinson cites the example of a couple in their early 60s who first purchased a home in 1967 for $45,000, sold it for $100,000 in 1972 and purchased a $105,000 replacement home. The couple deferred the $55,000 gain under the old “rollover” tax rules. Five years later the couple sold the 1972 house for $195,000, rolling over their gain tax-free by purchasing a $200,000 home. The couple moved and resold three more times over the succeeding years, eventually buying a $950,000 home in 1996.
Between 1972 and 1996, the couple deferred tax recognition on $850,000 worth of gains. If they sell the $950,000 house for $1.1 million – not an exceptional event, as the Harvard study documents – the couple faces what Robinson calls a “tax time bomb.” With an adjusted tax basis of just $125,000, stretching back to their original $45,000 basis in their first home purchase, the couple has a $975,000 cumulative gain. That is the sum of the gain on the sale of the current home ($150,000) plus their prior rolled-over gains of $825,000 dating to 1972. The capital gains tax bill, even using the full $500,000 exclusion: $71,250.
Couples like this can cut their taxes by retaining detailed records of the capital improvements they made on any of their houses to offset their gains. They can also just keep the property, allowing their heirs to acquire the house tax-free at its “stepped-up basis” valuation. A second strategy is to sell the house on an installment sale schedule, spreading out taxes over a period of years and providing an attractive annual income to the sellers. Another is a tax-free swap for a property that will be rented for a year, then occupied as a principal residence.
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Ken Harney is a real estate columnist for The Washington Post