Newland's Business Notes

Selling A Home – Missing the Tax-Free Slam Dunk

Volume 7 Issue 1 -- January/February 2003

How could Nord, a fallen, one-time NBA star miss the same tax “dunk shot” not once, but twice, when he sold his home? Those tall enough generally don’t miss a dunk shot on the basketball court.  Those who do proper tax planning don’t miss a tax-free dunk shot.

Congress created what, for most people who do a modicum of planning, amounts to a dunk shot to avoid taxation when they sell a home.  After 1997, it is possible for a married couple who files a joint income tax return to exclude up to $500,000 of gain from the sale of their residence (note, not just any house).  For those who are single or widowed, the amount of gain that can be excluded is $250,000.  The requirements for obtaining this tax-free treatment are generally easy to satisfy — own the house and live in it for two of the past five years. 

Remember, gain is not what you get from the sale; gain is computed by subtracting basis from the amount received.  For example, if you paid $200,000 for a house, made no improvements (your basis), then sold it for $700,000 and filed a joint return, the otherwise taxable $500,000 gain can be entirely excluded from taxation.  If the house were sold for $800,000, then $100,000 of the gain would be taxable.

How Can You Miss this Tax Dunk Shot?

The following case is an example of how, even with the benefit of the rather favorable tax laws, Nord, blew it.  While he still had some of his wealth from his long past professional basketball-playing days, Nord bought a home and resided there for a long time.  After receiving financial advice from others (who assisted Nord in learning how the rest of the world lives), Nord realized he needed to save what little money he had left. 

Nord moved into the Free Throw Complex, a federally assisted apartment complex, and rented his home to a third-party.  By doing so, he got the rent from the tenant, paid a relatively low rent to Free Throw, and pocketed the difference. 

After living at Free Throw for five years, Nord, in declining health, had to be admitted to a facility that provided nursing care.  At this point he had to move from Free Throw and sell his house in order to have the funds to pay for the much higher charges at Serious Injuries Nursing Center, “SIN Center.” 

Could Nord exclude $250,000 of gain when he sold his house?  The answer is “No.”  Nord was not eligible for that tax relief because he did not live in the house for two out of the past five years.  (Missing out on the exclusion was Nord’s first Missed Dunk.)

“But, isn’t there an exception for those living in assisted living facilities?,” you might ask. Yes, there is an exception that lowers the residence test to one year out of the past five.  However, Nord did not satisfy this exception either because he did not live in his former residence at all during the past five years. 

Moreover, the partial funding of Free Throw by the federal (or state) government does not make Free Throw a nursing facility to which Nord was admitted because he was “physically or mentally incapable of self-care,” as the Internal Revenue Code requires.  Free Throw was simply a discounted federal living facility where the tenants took care of themselves.

The Second Miss?

Nord was in bad health when he entered the SIN Center and was not expected to live long.  If he and his relatives had obtained a mortgage on Nord’s house and, instead of selling it, used the borrowed funds to pay Nord=s bills at the SIN Center, his heirs would get a “stepped-up basis” in the home to Fair Market Value on the date of Nord=s death.  Stepped-up basis means that, if the house was worth $800,000 when Nord died, the estate of Nord (or his heirs) could sell the house for $800,000 and pay no income tax. 

Unfortunately, that alternative was not available because Nord had allowed the tenant to make $25,000 of improvements to the house and Nord had already signed an agreement to sell the house.  (This was Nord’s second Missed Dunk.) Otherwise, the tenant could have been given an option to buy at the death of Nord and then the tax-free sale could occur. 

What is the Message?

Past newsletters have focused on the need to plan ahead for available tax benefits.  This is yet another example of how slam dunks can and will be missed by some families.

If you need tax planning, please consult with Newland & Associates.

Copyright 2003

Published by the law firm of Newland & Associates, PLC
9835 Business Way
Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and tax-related services.

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Newland's Business Notes is expressly prohibited without the written permission of Newland & Associates, PLC.

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