Calculating Capital Gains When Downsizing Your Home in Retirement
Three of our Relaxing Retirement members are in the beginning stages of downsizing and selling their primary homes right now, and each of them has inquired about capital gains taxes they will owe as part of their decision.
As you might imagine, we see this a lot. When you were younger and you had a family, having a lot of space in your home was very important: multiple bedrooms and bathrooms, a finished basement, a big yard, etc.
However, now that the kids are out on their own and you have transitioned to the next phase of your life as an “empty nester,” your big house, and all the physical responsibility that comes along with it, is not as appealing as it once was.
Should you sell your home and move into an arrangement that is more suitable to your current lifestyle? In all three members’ situations, in addition to all the time that went into finding a more suitable living situation, a big grey area and sticking point was the tax implication of selling vs. keeping it and passing it on to their children.
I thought it would be a good idea to share the brief case study I provided each of them to clarify what they can anticipate in their respective situations.
Case Study: Bill and Linda
Let’s assume for a moment that we have a couple, Bill and Linda, who are now 63 years old, and they have three children, all of whom are married.
Bill and Linda purchased the home that they now live in back in 1985 for $300,000. Back then, it seemed like all the money in the world, but it was worth it because it was a great house in a family neighborhood.
They have since paid off their mortgage completely so they’re debt free, including the line of credit they used to help with college tuitions.
Today, because they purchased their home in a very nice town, they’ve been told by a local realtor that their home is currently worth $1,250,000.
Hard to believe, but this is what has happened to housing prices in our area.
Tax Implications When They Sell Their Home
If Bill and Linda decide to sell their home right now, what are the tax implications?
What if they keep their home and the kids inherit it?
To understand what the implications will be, you have to become familiar with the term “cost basis”.
Cost basis is a “tax” term which equals your total cost in an asset like a home.
In Bill and Linda’s case, this starts with their purchase price: $300,000.
If they made permanent home improvements over the last 36 years, this would add to their cost basis.
In this case, let’s assume that Bill and Linda made $250,000 worth of improvements over the years, including a big addition, finishing 1,500 square feet of their basement, and a swimming pool.
This now brings their cost basis up to $550,000 ($300,000 original purchase plus $250,000 in improvements).
If Bill and Linda sell their home and walk away with $1,185,000 (after paying their real estate broker and closing costs), they may exclude their “cost basis” or $550,000 from capital gains taxes, thus leaving $635,000 subject to capital gains tax.
Capital Gains Tax Exclusion
Several years back, Congress passed a law that allows individuals to exclude $250,000 from the proceeds of the sale of your home, or a combined $500,000 if you’re married and own the property jointly.
So, in addition to being able to exclude their cost basis from taxes, Bill and Linda may also exclude another $500,000.
To summarize, if they sell their home for $1,250,000, pay their realtor and closing costs and walk away with $1,185,000, $1,050,000 is excluded from capital gains taxes.
To arrive at $1,050,000, we take their cost basis of $550,000 (purchase price and permanent home improvements), and their federal capital gains exclusion of $500,000.
$135,000 (the difference) is then subject to capital gains taxes which are currently either 15% or 20% on the federal level. And, at higher income levels with the Medicare surtax, add another 3.8% if your income is above $250,000. And, if you happen to live in Massachusetts, add another 5% tax.
In Bill and Linda’s case, assuming their other income placed them in the 20% capital gains tax bracket, they’d owe approximately $38,880 in capital gains taxes if they sold their home today.
Step-Up in Basis
This changes, however, if Bill and Linda decide to keep their home and pass it to their children at their death.
When you pass away, the cost basis in all your assets “steps up” to your date of death value!
This is significant.
In Bill and Linda’s case, if the value of their home at their deaths was $1,250,000, and their children sell their home soon after their deaths, $1,250,000 is excluded from the sales price as far as capital gains taxes are concerned.
In other words, the kids would pay no capital gains taxes if they sold their house for that same amount.
That’s a $38,880 difference!
As a side note, if the kids keep the house for a few years and later sell it for $1,450,000, they’d owe capital gains tax on the growth since the date of their parents’ death, or $200,000.
The Lesson When Selling Your Home
The lesson is to know your cost basis in all your assets (your home, your investments, your business, etc.)
When you know your cost basis, you can make calm, rational decisions based on fact. And that’s how you want to make all your decisions.