A Tax-Skipping Move for Seniors

A fantastic gain in the value of your home is, of course, a glorious thing. But there is a dark side: When it comes time to sell, you could owe a bundle in taxes.

Most homeowners are fully aware that when selling a home married couples can completely shelter up to $500,000 from any federal tax hit, while unmarried folks can exclude gains of up to $250,000. This means that many home sales trigger no tax hit whatsoever.

But in today's market — where the prices of homes have skyrocketed — the profits on many home sales will exceed these amounts. And that means you'll be stuck paying ugly capital gains taxes on the excess. (To see how much you might have to pay, run your numbers through our Home Sale Tax Estimator.)

Unfortunately, avoiding this tax hit is no easy task. But older homeowners looking to do a little estate planning do have a couple of options. That's because folks who are age 62 and older are eligible for something called a "reverse mortgage," which can actually be a handy tax-saver when used strategically. (Click here for the basics on reverse mortgages.) Here's what you need to know:

The Tax Advantages of Sitting Tight
The best way to avoid a potential tax hit? Don't sell your house. Holding onto your house until you or your spouse pass away creates a powerful tax break for your home's heir — whether that is the surviving spouse or someone else. In fact, it could greatly reduce or even eliminate the federal income tax bill when the property is eventually sold.

That's because of an obscure Internal Revenue Code provision that allows a step-up in basis (essentially your cost) for appreciated assets owned by a person who has died. Specifically, the basis of most assets subject to capital gains taxes, including personal residences, is stepped up to fair market value (FMV) as of the date of the owner's death. So if the value of an asset eligible for this favorable rule stays about the same between the date of death and the date of sale by the deceased owner's heirs, there will be little or nothing to report to the IRS.

Here's how this all plays out in the context of a greatly appreciated home: If you're married and your spouse dies before you, the basis of the portion of the home owned by your departed partner — typically 50% — gets stepped up to FMV. This removes half of all the appreciation that has occurred over the years from federal income tax. Then, if you continue to hold onto the home until you die, the basis of the part you own at that point (probably 100%) will get stepped up to FMV as of the date of your death. Your heirs can then sell the property and owe little or nothing to the U.S. Treasury.

If you and your spouse own the home together as community property — which applies to homeowners living in the nine community property states, which includes California and Texas — the tax basis of the entire residence is generally stepped up to FMV when the first spouse dies (not just the 50% portion that was owned by the now-deceased spouse). This strange-but-true rule means the surviving spouse can then sell the property and owe little or nothing to the IRS.

If you're unmarried and own the greatly appreciated home by yourself, the tax results are much easier to understand. The tax basis of the entire property will be stepped up to FMV when you pass on.

But I Need the Money!
One reason that many older homeowners sell their homes, of course, is that they need the money. For many seniors, their home is their greatest asset — something that they need to tap as they get older.

For those seniors who are house-rich but cash poor, a reverse mortgage can be a good way to tap equity without selling. Reverse mortgages allow people to use the equity in their home without having to pay the loan back as long as they live there. Over time, the mortgage principal gets bigger rather than smaller because you are not paying back any principal. Obviously, this is the reverse of how a standard "forward" mortgage works where you pay the lender every month and gradually reduce the loan's principal balance.

Typically, the reverse-mortgage lender will add the interest charges to the mortgage principal, which means the borrower need not make any payments to the lender until he or she dies or moves out of the home. At that point the property can be sold, and the reverse-mortgage balance (including any accumulated interest charges) gets paid off from the sales proceeds.

Seniors may object to the notion of borrowing against their homes to solve cash flow problems. But here's what to consider: If the cash you need comes from selling your greatly appreciated home, the cost of getting your hands on the money will be a huge tax bill. In contrast, if the cash comes from a reverse mortgage, the only cost will be loan fees and interest charges. Those may be a small percentage of the taxes you could permanently avoid by continuing to own your home. (If they are small a tiny percentage, this is not such a great idea.)

Of course, your need for cash and your desire to avoid triggering taxes if possible may not be the only issue here. You may strongly prefer to sell your home for other valid reasons — such as moving to a home that's smaller and easier to manage. But if you would be satisfied to remain in your home for as long as you can manage to pay the bills, the reverse mortgage idea may be the best tax-smart strategy for you.

There is, however, one final caveat: The strategy outlined in this article depends on the continued existence of the date-of-death basis step-up rule under the current Internal Revenue Code. This break is scheduled to be partially curtailed in 2010 when the federal estate tax is supposed to be repealed. Should you be worried? I don't think so. I think the estate tax will never be completely repealed, and I also think the beneficial basis step-up rule will still be around many years from now. That said, please don't just rely on my opinion. Talk to your tax adviser before making any moves.