Basic Estate Planning: Sale of Residence

Fact Sheet 9
EP-9
Community Development
Date: 
07/06/2012
James C. Skeeles, Ph.D., Extension Educator Emeritus in Agriculture and Natural Resources and Community Development, skeeles.1@osu.edu
Russell N. Cunningham, Attorney and OSBA Certified Specialist in Estate Planning, Trusts, and Probate Law, Barrett, Easterday, Cunningham & Eselgroth, LLP, rcunningham@ohiocounsel.com

For most, the home is usually the major asset. Homeownership is often achieved by retirement. Many will not consider selling their home or using up its equity during retirement, but some prefer moving to a smaller place or to an apartment that is maintained by a landlord.

This fact sheet will be of most interest to you if selling your home during your lifetime is a consideration. Also discussed are ways to stay in your home while selling its future interest. The next fact sheet discusses what to do if you plan to pass your home to an heir.

Old Law

In the past, gain in value of your home accumulated or was deferred as long as you purchased a home of equal or greater value than the previous one. Now there is a more favorable treatment of gain in value of personal residence for income tax calculation.

Exclusion of Gain on Principal Residence

If a single tax filer resides in a residence as his or her principal residence for two out of the preceding five years prior to a sale, $250,000 of gain ($500,000 for joint filers) can be excluded from income tax calculation when the home is sold. Generally, this benefit cannot be obtained more often than once every two years. This benefit replaces two prior provisions. One permitted gain to be rolled into a new residence; the other allowed a $125,000 one-time exclusion for taxpayers aged 55 or older. The present exclusion does not apply to sales of remainder interests to related parties, including for example, brothers, sisters, spouses, ancestors, or descendants.

For most, the gain while living in one's home will not approach the $250,000/$500,000 exclusion.

The present exclusion is much more liberal than the previous exclusion because not only is the dollar amount larger, but this exclusion can be used every two years whereas the earlier exclusion could be used only once per couple.

However, only the principal residence and surrounding yard—not an entire farm—qualifies for the $250,000 ($500,000 for joint filers) exclusion of gain from income tax. Furthermore, rules such as like kind exchange rules to defer income taxes on the gain in the value of business/farm property are much more stringent than the rules to exclude income taxes on the gain in value of your personal residence. Therefore, if the residence is part of a farm or other business property, the residence and farm/business property must be valued separately.

Transfer of property (sale, gift, inheritance) either triggers or defers taxes. Sale of appreciated property usually triggers income tax liability. Gifted property might be subject to gift tax, but it generally defers capital gain. Inheritance triggers the estate settlement costs discussed earlier. However, the sale of one's principal residence will likely be tax-free.

So You Sell Your Home, What Then?

Assume you can convert your home to cash, tax-free. How do you avert estate settlement costs on the cash received from the sale of the house? Selling the home, spending the proceeds during retirement, and giving any excess to children and/or grandchildren looks very good on paper to avoid taxes and estate settlement costs.

If the anticipated estate exceeds $5 million per spouse in 2011 and 2012, or $1 million thereafter, then it might be advisable to make yearly gifts of $13,000 per person per donee. However, if the estate is less than that depending on the year of death, the $13,000 limit might not be of concern. Even if one plans to get rid of every penny, the trick is deciding how much is needed for retirement. Most will not get rid of all reserves, but every dollar not in your estate evades estate settlement charges. Remember, however, that we are all living longer, so don't short yourself in your last years.

Gift to Children/Grandchildren

Giving extra cash for grandchildren's education or medical care might be appropriate. If tuition, hospital bills, etc., are paid directly to the institution, more can be gifted without reducing the federal or state estate tax exclusion. Because the financial needs of a family is greatest when the family is the youngest, your children and grandchildren will likely benefit more from gifts now than the benefit derived from the same dollars passing through inheritance.

Buy Life Insurance

What if you sell your home, don't want the proceeds to be included in your estate, don't need the money, but don't want to give the money to others until you die? One option is to use the proceeds from the sale of the house to purchase life insurance. The insurance company will make a profit, and premium costs will be more the older you are. Therefore, you might end up paying close to the face value of the policy in premium payments.

If you want to make sure the value of the policy won't enter into estate tax calculations, your heirs not only have to be the beneficiaries but also have to be the owner of the policy. That means they need to pay the premiums and have the right to change beneficiaries or cancel the policy. Look at this option with an accountant or financial advisor. Savings in estate settlement costs won't likely offset the charges for the life insurance.

Irrevocable Living Trust

Trusts have become increasingly popular. Let's consider some advantages and disadvantages of putting the proceeds of the sale of one's home into a trust. Remember that there are different kinds of trusts and that each is treated differently. Just a few short notes seem appropriate concerning putting the proceeds from the sale of a home into a trust. With testamentary trusts (those created by a will), cash will be treated as any other liquid asset. With a living trust, you can have a trust department at a bank manage the cash, even though there will be a fee for doing so. Remember that family members can also be trustees. If the living trust is revocable or you otherwise have control over the assets in the trust, the assets in the trust will be subject to estate taxes just as they would have been if not in the trust. If the trust is set up as a living irrevocable trust, a gift might occur upon funding the trust; this might use up some of your unified credit if the gift exceeds $13,000 per year or if the trust is not drafted in such a way as to allow it to qualify for annual exclusion purposes. Once the $5 million federal exclusion amount in 2012 and possibly $1 million thereafter for gifting is used up, gift tax might be due and any assets held at death might be assessed federal estate tax. Consult your accountant and attorney if considering gifts approaching $5 million in 2011 and 2012, or $1 million in 2013 or thereafter.

Sell Your Home But Live There The Rest of Your Life

The outright sale of your home/property while living is the simplest and might be the best option if the maintenance and upkeep of the home/property becomes a burden, financially or emotionally. This is often the case for the elderly or for those in poor health. However, many wish to retire in place and do not wish to move from their home. Here are some ways to get cash from the equity in your home but still live there the rest of your life: reverse mortgaging or selling only the remainder rights (retaining a life estate).

Reverse Mortgage

In a reverse mortgage, you own the home but you mortgage the home to someone else. A reverse mortgage is very similar to the increasingly popular home equity loan. In a home equity loan, you mortgage only part of the value of your home, but with a reverse mortgage, usually all of the home is mortgaged. Part of the agreement for a reverse mortgage is usually that you can stay there the rest of your life. The buyer of a reverse mortgage usually pays you over a long period of time and usually in equal payments during the rest of your life (annuitized payments). Sometimes the mortgage purchaser pays you an annuity for only a set period of time. As payments are made, the owner's equity in the home reduces, but for annuities, payments continue even if more is paid than the home is worth. If the owner vacates the home or dies before expected, the heirs or owner is paid the remaining equity.

A reverse mortgage might be considered if the equity in the home will be of more benefit to the owner while living than to the children or heirs after the owner dies. A reverse mortgage provides income to the owner so that he or she can have a higher standard of living during retirement. It can also reduce estate settlement costs if the cash payments are spent or given so that their value is not included in the estate.

However, with a reverse mortgage, there will be less or no equity in the estate from the home to be passed on to heirs.

Life Estate

In a life estate, you sell only the remainder interest of the home while retaining the life interest or owning the property as a life estate only. This also allows the owner of the life estate to live his or her lifetime in the home while using the equity in the home for retirement or other purposes. When the owner sells the remainder rights but retains the life estate, he or she retains the right to live in the house or use the property as he or she wishes for as long as he or she lives. However, upon death, the home or property automatically goes to the owner of the remainder interest. Owning a life estate and selling remainder rights might be a better option than a reverse mortgage if the owner wishes to stay in the home but desires an up front, lump sum payment rather than spreading out payments over a period of time. However, be cautious of giving remainder rights to relatives.

Often considered is retaining the right to live one's lifetime in the home (life interest) but instead of selling the remainder rights, gifting them to the would-be heirs. This seems simple and straightforward, but let's consider several potential pitfalls.

First, if the remainder interest is given to would-be heirs and the life estate is retained, the total value of the property is included in the donor's estate. Therefore, doing this seldom saves taxes.

Second, the person with the life estate is granted only the use and benefits of the property for life. The person with the life estate cannot make major changes that would greatly decrease the property's value. More importantly, the person might not be able to use the property as collateral for a loan. This could be problematic for a son or daughter who is gifted only a life estate in a farm. In general, life estates allow for little flexibility and need to be critically evaluated by estate planning professionals.

If tax savings is an issue, you might want to consider a qualified personal residence trust. In a qualified personal residence trust, you retain the right to live in the residence for a term of years; at the end of the term, you pay rent to the beneficiaries named in the trust.

Conclusion

Selling or giving one's home is not for everyone. However, because of the exclusion of capital gains of $250,000 ($500,000 for joint filers) on principal residences, it is possible to sell one's home and not pay income tax on the capital gain. If a homeowner needs the money and will benefit more from the equity in the home than will the heirs, sale of the home outright, a reverse mortgage, or keeping the life interest but selling the remainder rights should be considered. The later two will allow the homeowner to reside in the home the rest of his or her life.

These fact sheets should in no manner be considered as a replacement for consulting with estate planning professionals, nor should the general principles in these fact sheets be applied to specific situations without consulting with an attorney. 


Your Response

Fact Sheet 9

1. Joe and Mary purchased their home 50 years ago for $20,000 and just now sold their home for $200,000. They file a joint return and have lived in the home during their ownership. Will any of the gain cause increased income taxes?

_____ Yes      _____ No

2. Elizabeth is a widow who paid $15,000 to Wooster College for tuition, room, and board for her granddaughter. Will her federal estate tax exclusion be reduced?

_____ Yes      _____ No

3. Elizabeth is a widow who sold her home for $200,000. Name several of her options to avert estate settlement costs to be charged on the $200,000.

________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________

Options to get cash from your home but still live there the rest of your life include reverse mortgaging and selling remainder rights while retaining a life estate.

4. Which of the above generally gives monthly payments?

5. Which of the above generally gives an up front, lump sum payment with the payment being generally less than it would be for an outright sale?


Answers

Fact Sheet 9

1. Joe and Mary purchased their home 50 years ago for $20,000 and just now sold their home for $200,000. They file a joint return and have lived in the home during their ownership. Will any of the gain cause increased income taxes?

_____ Yes      __X__ No  

No, the total gain ($180,000) is less than the $500,000 exclusion available. The total gain is figured by deducting the basis ($20,000) from the sale price ($200,000).

2. Elizabeth is a widow who paid $15,000 to Wooster College for tuition, room, and board for her granddaughter. Will her federal estate tax exclusion be reduced?

_____ Yes      __X__ No 

No, even though only $13,000 per person per year can be given before the federal estate tax exclusion is reduced, if the contribution is given directly to an institution such as a university or hospital, there is no limit.

3. Elizabeth is a widow who sold her home for $200,000. Name several of her options to avert estate settlement costs to be charged on the $200,000.

• Spend the $200,000 while living.

• Purchase life insurance with heirs as owner and beneficiary of the policy.

• Gift the $200,000. If Elizabeth's estate is less than $1 million, she doesn't need to concern herself with the $13,000 per person per year limit.

If the $200,000 is held by Elizabeth upon her death, it will add to the total amount of assets upon which estate settlement costs are calculated. If her estate is less than $1 million, she can certainly ignore the $13,000 limit; she can likely ignore it if less than $5,000. She can likely gift over $13,000 per person per year and still have adequate federal estate tax exclusion remaining to avert federal estate taxes unless her estate is quite large.

Options to get cash from your home but still live there the rest of your life include reverse mortgaging and selling remainder rights while retaining a life estate.

4. Which of the above generally gives monthly payments?

Reverse mortgaging

A reverse mortgage is the opposite of a regular mortgage. In a regular mortgage, the individual pays the institution. With a reverse mortgage, the institution pays the individual, generally on a monthly basis.

5. Which of the above generally gives an up front, lump sum payment with the payment being generally less than it would be for an outright sale?

Selling remainder rights while retaining a life estate

If one sells remainder rights to a home/property, he or she has sold the right to will it to another person upon death. This can be sold (usually paid all at once) or given. However, retaining the life estate gives the holder the right to the use of the property as long as he or she lives.

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