A new administration might bring real estate tax changes. No matter what happens in this area, it’s worthwhile to know what’s going on that might affect your plans to bequeath your real estate. So here we take a look at taxes on capital gains, and then at one form of tax relief that’s now a complete question mark: the stepped-up cost basis of real property for your heirs.
Capital Gains: What They Are, How They’re Taxed
Capital gains are the increase in value that you’ve earned on an asset, such as your home, at the time you transfer the deed to someone else. What you paid for the house is its tax basis. The amount of appreciation you realize if you sell your home, over and above that tax basis, constitutes your taxable gain.
Therefore, capital gains, like other forms of income, are taxed. This does not become an issue until the year you transfer the deed to someone else. In the best tax scenario, you don’t transfer your house quickly after buying it. If you sell the home in the first year you own it, you pay the higher short-term capital gains rate, so it’s like having regular income.
But long-term capital gains receive a tax advantage. If you keep your home for more than a year, you pay a much more comfortable tax rate on those gains. Longevity has its rewards!
Now, for 2021: Will capital gains tax go up after a change in administrations? Likely so. But for now, this change will only affect people who have an income of more than a million per year.
OK, what about exclusions? You may use the capital gain exclusion allowance — $250,000 an individual taxpayer, $500,000 for a couple filing jointly — if you’re selling a home that’s been your primary residence for at least two of the past five years. You’ll need to wait at least two years after your sale to qualify for this exclusion again.
Pro tip: The IRS may permit a partial exclusion from capital gains tax (“partial exclusion of gain”) if you are forced to sell your primary home because of a life change.
Stepped-Up Cost Basis: Are Your Heirs About to Lose It?
An administration change in 2021 may mean the end of the stepped-up cost basis, which currently lets heirs sell inherited homes without steep capital gains taxes. It might or might not happen, because Congress will have a say in whether it’s approved or not. But it’s being discussed. So, it should be on every homeowner’s radar.
First, a quick refresher on the stepped-up cost basis.
As noted above, a home that appreciates in value while you own it earns you a profit — a capital gain — when you sell. But if you don’t sell, and instead bequeath the home, are your beneficiaries taxed on the home’s entire rise in property ever since you first acquired it?
No. The tax code does not leave the heirs with the taxable capital gains burden of the person who passed away. When will or trust beneficiaries inherit the home, there is simply no sale, and therefore no income to be taxed.
Will they have to pay taxes on your increase in value if they turn around and sell the house? No, not even then. Today, if you bequeath your home to someone through a will or a living trust, the beneficiaries get to start with the value of the home at its fair market value when you pass away. They receive their own new tax basis from that “stepped-up” value. By avoiding taxation on the entire rise in value of the home since you first acquired it, your beneficiaries can dramatically reduce their taxable capital gains if they sell the home. This has been a key provision for families that wish to save on tax costs and pass wealth from one generation to the next.
What Is the Purpose of Changing These Tax Provisions?
The policy debate involves whether or not a long-untapped possible source of tax revenue should be captured.
From the federal government’s point of view, the step up in tax basis for beneficiaries means that profit gained from the property during the deceased owner’s life simply goes untaxed. Moreover, the stepped-up basis offers the highest benefits to the people who hold the largest, most lucrative assets. That’s why there’s pressure to end this provision.
If this tax break ends, the transfer of the home upon death will be a taxable event. The estate would have to pay capital gains on behalf of the deceased. The taxed “income” would be the rise in market value from the original date the deceased person acquired the home to the date of the transfer. And this will happen whether or not the beneficiaries want to sell the house or keep it.
☛ Have you inherited real estate? Here is your guide to selling an inherited home under the current tax code, as well as alternatives to selling the bequeathed property.
Clearly, the proposed real estate tax changes, if enacted into law, will shift a great deal of wealth away from homeowners and away from the beneficiaries of their wills and trusts. Meanwhile, the federal government will gain a great deal of revenue. This new revenue stream would be available to fund the new administration’s expansion of affordable medical care plans.
From the taxpayers’ perspective, this change, if enacted, will create new burdens. If you are a homeowner, you’ll need to make sure the beneficiaries of your will or trust have verifiable information on your original cost basis of the home. Keep this information with your estate documents. This way, you anticipate possible changes and offer information that helps your beneficiaries through probate, and helps your personal representative through your final tax return process.
The Importance of Seeking Professional Advice
Successful deed transfer planning is both situation-specific and highly sensitive to the current tax codes, both federal and state. Your tax pro can guide you in contrasting the tax burden impacting a deed transfer under the current code versus under the new provisions which could become enacted.
So, if you are assessing your current estate plan, or contemplating transferring substantial assets, speak with your tax expert for professional advice. We also strongly encourage beneficiaries to obtain legal advice from a neutral lawyer with experience in the matter before they transfer the deed to their inherited home.
What Other Changes Will Impact Owners, Buyers and Sellers Ahead?
We see several important trends on the horizon, Specifically, we:
- Expect U.S. real property values to continue their impressive rise throughout 2021 and 2022. Appreciation in value could be around 3%.
- Foresee low interest rates sticking around for a while. Expect people to keep making plans to buy houses in 2021 and 2022 to take advantage of the low-interest environment.
- Look for millennial home buyers to be the major force in the market. Catering to their expectations will drive technological advancement in the world of real estate agents, mortgage lenders, and insurers.
- Expect the smart-home trend to flourish, and the growing emphasis on ecofriendly features to blossom.
- Look for suburban homes to enjoy continued high demand in the near future.
See more here about our expected near-future trends in the real estate market.
Of course, preparation for the future is an uncertain art. Yet it does heighten our awareness. At Deeds.com, we look forward to supporting our readers’ quest for knowledge in the days and years ahead.
Darla Mercado, CFP®, This Is How Joe Biden Will Tax Generational Wealth Transfer, CNBC (Mar. 13 2020).
Photo credits: Fran Hogan and Anne Nygård, via Unsplash.