Real property in the Hamptons has always enjoyed a steady increase in value. But with this increase in value, owners may incur a substantial tax bill from the capital gain in their real property if and when they decide to sell. Federal long-term term capital gains are taxed at the rate of 0%, 15% or 20%, depending on the seller’s income and marital status. In addition, New York capital gains are taxed as ordinary income. Fortunately, if the property being sold is a primary residence in which the seller has resided for 2 or more years, the seller can claim the benefit of a $250,000 exclusion ($500,000 for a married couple). In addition, sellers can deduct any capital improvements they have made over the years.
Taxes on the Sale of a Primary Residence
Even for a modest couple living on the east end, the capital gain is a huge consideration when contemplating a sale. For example, consider the case where a married couple owns a primary residence in Sag Harbor. In 1979 they purchased the property for $100,000 and, over the years, expended $400,000 on home improvements. The basis for capital gain purposes is therefore $500,000. Assume they now receive an offer to sell and will net $3 million after closing costs. Each spouse can claim each a $250,000 exemption from capital gains, shielding $500,000 from capital gains tax. Accordingly, the gain on which they will be taxed is $2 million dollars, resulting in a substantial tax bill.
How can this hefty capital gains tax be avoided? One method is to wait until one spouse passes away and the surviving spouse receives a step-up in basis for one-half the value of the home. This is possible because, at death all property owned by the decedent spouse, not just the primary residence, gets an increase in basis equal to fair market value as of the date of death. So, in our example above, when the first spouse dies, that spouse’s one-half gets stepped up to $1.5 million. At a subsequent sale, the surviving spouse’s basis is $250,000 plus the $250,000 exemption. This, coupled with the step-up received at the first spouse’s death, places the basis in the real property at $2 million. Thus, the surviving spouse only pays capital gains on $1 million, resulting in a significant savings.
100% Step Up Basis
There is also a way to save even more capital gains – in fact even reduce the tax to zero. The surviving spouse may be able to avoid all capital gains tax on a sale if they purchased the property before 1977. In that case, there is a 100% step-up in basis at the death of the first spouse. The “catch” is that you are only able to get the full step-up in basis at the death of the first spouse if that now deceased spouse contributed all the money to the purchase of the property. These were the facts of the now famous Gallenstein case where the Court found in favor of the tax payer and awarded a 100% step-up in cost basis at the death of the first spouse for a property that had been purchased pre-1977 when Congress changed the tax law.
In order for this “double step up in basis” to apply, the deed must have been continuously in both names pre-1977 until the death of the first spouse. Transferring the deed will negate this benefit, even if the deed is later transferred back into both names. The moral of the story is to always review the chain of title of the deed. If the deed is owned by both spouses before 1977, speak to an attorney before making any changes to the deed.
What if the house was not purchased before 1977 or if there had been a change to the deed? A 100% step up in basis at the death of either spouse can still be achieved by placing the home or property into a joint revocable trust. If drafted properly, the surviving spouse can completely eliminate capital gains tax on a sale after the death of either spouse, regardless of who contributed to the purchase of the property. Also, any assets, real or personal property, owned by the trust will get a the double step up in basis.
Any such trust must be part of a comprehensive estate plan that considers estate taxes as well. Potential estate taxes are especially relevant now, with large government spending. In a post-COVID and post-election society, we may well see a reduction in estate tax exemptions. For high value estates, a varied approach that does not place all assets into a joint trust is necessary if both spouses’ estate tax exemptions must be captured, as the estate tax rates are higher than long-term capital gains tax rates.
Tax Planning for High Value Estates
Estate planning is nuanced, there are pros and cons to every estate planning technique. It is important to review your specific situation and goals with an experienced estate planning attorney to ascertain the most beneficial choice for you.