How Can You Reduce Your Capital Gains Taxes?

Diane, at age 80, resides in the home she has lived in for nearly 40 years. When she initially purchased the home after her husband’s death, it cost only $25,000 (and she since put in $45,000 in improvements); today it’s worth at least $675,000. Diane’s only child, Michael, moved in with Diane several years ago to help out his mother since her advancing age and declining health were making it difficult for her to live alone. Diane, like most people, wants to leave her home to her son upon her death, and has even considered gifting it to him now, while she’s still alive. Diane hasn’t decided whether she wants to move someplace else in the future, so it may be she remains in the home until the end and Michael inherits the home when she passes away. Diane doesn’t know much about taxes, but similar to most people, she wants to reduce them as much as possible, including the capital gains taxes Michael will have to pay on her home whether she gives it to him while she’s alive or as inheritance when she passes away.

What is a Capital Gain?

A capital gain occurs when you sell something (a capital asset) for more than your basis (what you spent to acquire it, including any improvements made over the years in the case of real estate). This happens mostly with investments and real estate. Anyone who sells a capital asset should know that capital gains taxes may apply, but luckily there are some ways to reduce or even eliminate the amount that needs to be paid.

How Much Are Capital Gains Taxes?

Capital gains tax is typically 15% federally, unless you have either very low or very high income, and whatever your state’s tax is (VA state capital gains tax is 5.75%; Maryland is 5%; and Washington, DC is 8.5%.)

There are three exceptions:

1. If you sell an asset after owning it for more than a year, any gain you have is a “long-term” capital gain. If you sell an asset you’ve owned for a year or less, it’s a “short-term” capital gain. The amount you pay in taxes for short-term capital gains is usually significantly larger than that for long-term gains, because short-term capital gains are taxed as ordinary income at ordinary income tax rates, which are, for most people, higher than capital gains tax rates.

2. People in the lowest tax brackets usually don’t have to pay any tax on long-term capital gains. For instance, if your taxable income, including the capital gains, is $38,600 or less for a single person and $77,200 for a married couple (in 2018), there is no federal tax on capital gain. However, capital gains will be included in the calculation and could put you over the threshold.

3. If your income is more than $425,800 for a single person and $479,000 for a married couple (in 2018), the federal capital gains tax rate is 20%, bringing the combined federal and assumed state rate up to just over 25.75% for Virginia, 25% for Maryland, and 28.5% for DC.

Your May Qualify for an Capital Gains Exemption

The single biggest asset many people have is their home, and depending on the real estate market, a homeowner might realize a huge capital gain on a sale. The good news is that the current tax code allows you to exclude some or all of such a gain from capital gains tax, as long as you meet three conditions under Internal Revenue Code (IRC) Section 121:

• You owned the home for a total of at least two years in the five-year period before the sale;
• You used the home as your primary residence for a total of at least two years in that same five-year period;
• You haven’t excluded the gain from another home sale in the two-year period before the sale.
If you meet these conditions, you can exclude up to $250,000 of your gain if you’re single or $500,000 if you’re married and filing jointly.

Gifting Property and Capital Gains Carryover Basis

In the case of Diane in our example, if she gifts the home to Michael while she is still alive, Diane’s basis would transfer to Michael as “carryover basis,’ meaning Michael’s basis would remain the same as when Diane owned the house, and if Michael were to ever sell the house, he would be forced to use his mother’s basis of $70,000 when calculating gain on the sale.

Let’s say that Diane gifts the property to Michael and Diane dies a year later, at which point Michael sells the property for $700,000. This would mean that Michael would have a short-term capital gain of $630,000 subject to ordinary income tax. That’s a good day for the IRS, but not so much for Michael.
Let’s say Diane gifts the property to Michael and Diane dies 10 years later, at which point Michael sells the property for $900,000. This would mean that Michael would have a long-term capital gain of $830,000 subject to long-term capitals gains taxes. Assuming the house is in Virginia and Michael pays capital gains tax of 25.75%, this means Michael would owe a capital gains tax of almost $214,000. If Michael had continued to live in the property as his primary residence after his mother’s death and met the IRC Section 121 exemption requirements explained above, then Michael would get a $250,000 exclusion from capital gains, but he’d still have to pay capital gains taxes on $580,000 of gain, which would equate to a tax bill of almost $150,000.

Avoiding Capital Gains Tax Through Inheritance

When someone dies, the property that person leaves as a gift to others receives a “step up” in basis to the property’s fair market value on the date of death. In our example above, let’s say Diane leaves Michael the house valued at $900,000 after she passes away 10 years from now. Even though Diane’s original cost basis in the home was $70,000, because Michael received this property upon his mother’s death — through her will or through a properly-drafted living trust, he inherited the house, but he did not inherit her low tax basis. Instead, the basis is “stepped up” to $900,000, the house’s fair market value at the time of her death. Therefore, when Michael sells this house for $900,000, he has no capital gain, which saves him either $150,000 or $250,000 in capital gains taxes compared to if his mother had gifted him the house while she was alive.

Living Trust Plus™ in Virginia, DC, and Maryland

Let’s say Diane in our example strongly wants to give the house to Michael while she is still alive, perhaps because she is rightfully concerned about the possibility of needing nursing home care, and she wants to protect the house by transferring it to her son at least five years before she needs nursing home care? How can she avoid him having to pay the high capital gains taxes described above? The best way is for Diane to protect it now by giving it to Michael though a properly-drafted asset protection trust such as the Living Trust Plus™. By doing so, Michael will still get a “step-up” in basis on Diane’s death because the trust is drafted in such a way that the trust assets are intentionally included in Diane’s taxable estate upon her death, even though the assets are protected in connection with Medicaid after the expiration of the Medicaid five-year look back period.

The Living Trust Plus™ functions very similarly to a revocable living trust and maintains much of the flexibility of a revocable living trust, but protects your assets in connection with the nightmare and expenses of probate PLUS lawsuits PLUS Veterans Aid and Attendance benefits after 3 years PLUS Medicaid benefits after 5 years.

If you’re a client or potential client who would like more information about the Living Trust Plus™, please read this page and then click here to contact us for an appointment.

Estate Planning Lawyer Northern Virginia, DC, and Maryland

Do you have a home that is worth a lot more than you paid for it? Before you sign a deed to transfer your residence to your child(ren), please consider discussing your situation with a Certified Elder Law Attorney such as myself. We’d be happy to discuss more about the Living Trust Plus™ and other strategies that will work for you and your loved ones. Please contact us at anytime to make an appointment for an initial no-cost consultation:

Medicaid Asset Protection Attorney Fairfax: 703-691-1888
Medicaid Asset Protection Attorney Fredericksburg: 540-479-1435
Medicaid Asset Protection Attorney Rockville: 301- 519-8041
Medicaid Asset Protection Attorney Washington, D.C.: 202-587-2797

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