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by Jonathan Pond
The first part of our analysis of the 1997 tax law ("Tax Relief for Retirement Savers," January-February 1998, page 24A) reviewed the new rules governing individual retirement accounts and capital-gains taxes. Of no less importance for most retirement savers and retirees are the changes applying to taxation of home sales--for many people, their biggest asset and largest source of capital gains--and taxation of gifts and estates. These overlooked financial and tax issues are the subject of this article.
HOME SALES BONANZA
The new tax rules on home sales are a real boon for taxpayers.
In general, for the sale or exchange of a principal residence after May 6, 1997, the capital gains you may exclude from taxation have been increased significantly-- from the former $125,000 for either single or married taxpayers, to $250,000 for single taxpayers and $500,000 for joint filers.
The age-55-and-over restriction has been abolished. Homeowners of any age are eligible.
The once-in-a-lifetime limit has been eliminated. The gain, if any, may be realized and excluded from taxation throughout your lifetime, subject to a once-every-two-years limit.
The aggregate residency requirement--how long you must have made the house your primary residence--has been liberalized to two out of the five years prior to the sale.
Naturally, there are a few technical matters to keep in mind. Married, separated, or divorced taxpayers can use the $500,000 exclusion even if only one spouse owns the home, so long as both meet the use requirements. In the case of a tax-free property transfer between spouses or former spouses, the recipient of the home can add the transferor's ownership period to his or her own. But one spouse's ineligibility for the exclusion won't prevent the other qualified spouse from claiming the single-taxpayer exclusion amount.
Finally, partial exclusion is allowed for "forced sales." Taxpayers who fail to qualify for the exclusion under one of the rules (either ownership or use) when they have to sell their principal residence owing to certain unforeseen circumstances--a job change, for example, or ill health--may qualify for a proportionate exclusion. And for sales during the two-year period beginning August 5, 1997, if the taxpayer held the home on that date and fails to meet the two-out-of-five-year ownership and use rule, then the partial exclusion provision applies no matter what the reason for the sale.
But remember: depreciation is not included. The exclusion does not apply to capital gain attributable to any depreciation that is claimed after May 1997 for rental or business use of the residence. This means that any portion of the gain that results from depreciation is subject to tax at a maximum rate of 25 percent.
Many will benefit. The combination of increased limits on the amount of gain you can realize federally tax-free, plus much more liberal rules on who qualifies and how often, makes an enormous difference in calculating the economics of homeownership. For most taxpayers, the new rules make the primary residence an even more compelling investment. And people who like to renovate old houses, occupy them, and sell them for a hefty profit can now accumulate significantly greater tax-deferred gains.
The home has been turned into a powerful retirement investment for those who want to downsize their home or move to a rental when they retire. Suddenly, older homeowners, or homeowners who have lived for a long time in an area where residential real estate has appreciated sharply in value, can contemplate a sale and relocation to a more suitable residence without having to pay enormous federal gains taxes. In fact, Realtors in certain markets expect the new provisions to have a real effect on owners' willingness to sell appreciated properties.
ESTATE TAX BURDEN EASED
At the risk of punning, we can truly say that the new law means less taxation without respiration. Although one member of Congress advocated complete repeal of the estate tax under the slogan "No taxation without respiration," the legislation enacted means that there will be less taxation for the future deceased. The old $600,000 exemption from estate taxes took effect at the beginning of 1987. At last, the exemption will be gradually raised to $1 million over the next decade, belatedly taking into account part of the effects of inflation since the 1987 law. The so-called "unified credit" will rise in a series of unequal steps, so that estates resulting from deaths during 1998 will exempt from estate taxation the first $625,000, and so on up to $1 million for the year 2006 and thereafter. To take full advantage of this provision, be sure to consult with your estate and tax advisers; your estate-planning documents should specify the maximum available amount capable of being passed on tax-free, rather than a particular dollar figure, such as the old $600,000 limit.
The new law also made available additional estate-tax relief for the families of farmers and small-business owners who, under the old rules, were often forced to sell the family farm or business. Now, small businesses and family farms will be treated as a separate class of estate assets eligible for a $1.3 million estate-tax exemption--if they meet certain requirements. But the requirements are strict, so don't get your hopes up before checking with your tax professional.
GIVING GIFTS
Beyond the estate-tax revisions, the new treatment of gifts makes another estate-planning tool more powerful.
Under current law, the annual gift exclusion allows you to give individual gifts of up to $10,000 per year to any other person or persons, without having to pay a gift tax. Such gifts obviously reduce the value of your estate, and therefore enable you to pass assets on during your lifetime, while minimizing future estate taxes.
The 1997 law puts into place a mechanism to index the allowable gift amount for inflation in the future. But there is a hitch: the exclusion will be increased only in $1,000 increments. That means that the cost of living will have to rise by an aggregate of 10 percent before the current $10,000 exclusion level is increased. This will probably take a few years.
In the meantime, though, the new law performs the useful function of calling attention to the gift exclusion--and might even encourage you to indulge your generous instincts and engage in tax-planning strategies at the same time.
SUMMARY
Taken as a whole, the 1997 law offers significant new opportunities for tax-favored savings, and for the use of all your investments to secure a financially comfortable retirement.
Decreased capital-gains tax rates and the liberalized treatment of gains on the sale of residences may have even more widespread application to many people's daily financial planning and management than the new IRA rules. And the overdue, gradual adjustment in the sums excluded from estate and gift taxes should remind all of us to make prudent, effective plans today for our families' financial future.
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