Tax Strategies and Capital Gains

Part 1: Selling Your Principal Residence

During tax season, we saw a significant increase in the number of clients paying tax on capital gains. Many stock portfolio investments hit record highs in 2021 which was the catalyst for many individuals to sell certain assets and for many funds to pay out significant capital gain distributions. Also, home sale prices saw an 18.8% increase in 2021 which provided a catalyst for individuals to sell their principal residence. In many cases, the sale of those capital assets triggered capital gain taxes.

What is a Capital Asset?

According to the IRS, almost everything you own and use for personal purposes, pleasure, business or investment is a capital asset, including:

• Your home
• Stocks or bonds
• Collectibles
• Gems and jewelry
• Gold, silver or any other metal, and
• Business property

Today’s focus will be on the tax consequences of the sale of your principal residence.

How is a Capital Gain Realized?

When you sell one of your capital assets, a capital gain occurs if the asset is sold for a price higher than its basis.

WM WISDOM:

Keeping good records on cost and additional investments and contacting your CPA before you sell will help you avoid surprises.

Example: Selling Your Principal Residence

The largest investment for many individuals is their home. There are important factors to consider if you are selling your principal residence and the potential tax impact has to be a part of the decision-making process. Gains on your principal residence are subject to tax, however, you may qualify to exclude up to $250,000 of that gain from your income. If married and filing a joint return, you may qualify to exclude up to $500,000 of that gain. 

Keep in mind that the IRS has qualifying ownership and use tests that you must meet in order to qualify. The length of time that you lived in the home will be used to determine if you can meet the ownership and use tests during different 2-year periods. A CPA will be able to provide you with the information you need to receive the maximum tax exclusions as well as submitting the appropriate forms with your tax return.

Example: Inheriting and Selling a Home

If you have a parent or loved one who is elderly or terminally ill, often, selling their principal residence before their demise could lead to paying more capital gains. Keep in mind that the basis used to determine the capital gain on the sale of the home is based on how much the owner paid for the home plus any improvements.

If your parent or loved one purchased the home for $150,000 in 1990 and spent $100,000 on capital improvements while they owned the property their basis to calculate capital gains would be $250,000.  If the property is now sold for $800,000, they have a gain of $550,000 ($800,000-250,000).  Assuming they qualify for the personal residence exclusion they can reduce the gain by $250,000 (filing single) but are still left with a taxable capital gain of $300,000.  

If the sale takes place after the death of your loved one the tax picture changes significantly.  Upon death, the beneficiaries of the property receive a “step-up” in basis on the property to the fair market value (FMV) at the date of death.  The basis for calculating a capital gain now becomes that FMV rather than the cost. 

Using our example above and assuming the FMV at the date of death was $750,000, a sale at $800,000 would generate a $50,000 ($800,000-750,000) capital gain which is significantly less than the $300,000 calculated above. Note that the personal residence exclusion is no longer available as the property is now owned by the beneficiaries.

Plan Ahead to Reduce or Limit Capital Gains

If you anticipate a sale of a capital asset, we recommend setting up a time to speak with your CPA to discuss tax planning strategies that include:

• how to reduce or limit capital gains in the future
• estate planning
• business succession planning
• retirement strategies
• trusts

We are available to meet and discuss how to create an individual plan for you and your family.

As always, should you have questions about this topic, or any other topics related to your personal or business situation, please contact us at any time.

Part 2 of this Capital Gains series will be on Stock Portfolio Investments and published on May 4, 2022.

DISCLAIMER: The WM Update, WM Wednesday Wisdom, WM Daily Update COVID-19, COVID-19 Business Resources, COVID-19 Client News Alerts and other related communications are intended to provide general information, including information regarding legislative COVID-19 relief measures, as of the date of this communication and may reference information from reputable sources. Although our firm has made every reasonable effort to ensure that the information provided is accurate, we make no warranties, expressed or implied, on the information provided. As legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that may modify some of the provisions in this communication. Some of those modifications may be significant. As such, be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed.