TAXED IN

It’s a fascinating situation but many people get “Taxed In” into their existing home ownership and can’t or won’t move to somewhere else they want to – rather it is to downsize, retire, simplify their lives, or move to a new area in the country.

I don’t think the intent of Congress or the Senate or anybody of people would really want to deny a couple, family, maybe a retired person or couple from the flexibility to move elsewhere. IE you have spent your entire life working your job, getting your kids through school, paying down your mortgage but you can’t move.

Maybe you are ready for a smaller house or want to move to the countryside or mountains for your retirement, maybe you want to move closer to grandchildren. Or maybe you want to make an economic decision on maximizing the value of your house at a certain time and use the value you have built up for any of the same reasons or others.

Why do you get “Taxed In”? Because of the laws for both federal and potentially state income taxes on sale or transfer and potentially because of state and local real estate taxes.

This is not just a rich man’s problem either.

I’ve seen it here in Naples where a down to earth, simple couple wanted to sell their house which they bought 35 years ago for $100,000 – now worth many times that figure, thought about selling and they could have a very comfortable retirement wherever they wanted. Or they could downsize, but still pay a lot for any new local house as the entire area has increased in value. If they move, they have to pay the Federal capital gains tax less the $500,000 deduction for a couple, and they can only port with them a portion of their locked in real estate maximum tax saving they have had for 35 years. So, they end up in a situation where they pay income tax on their primary residence sale to buy another slightly less expensive place but also get a step up in their annual real estate tax bill. Not a good picture for a lot of people.

But I’ve also seen it in Chicago, in California and in Boston. It also definitely affects the small farming family across the midlands. Similar situations occur in other states where they give a benefit to “homesteads.”

Income Side: The Section 121 deduction limitation on gain of $250,000 for a single individual or $500,000 for a couple sounds like a rich person’s problem and it is from the perspective of the entire US and net wealth spectrum. But for somebody who has worked hard, been a part of a community, paid down their mortgage, saved for the future – it really isn’t. It also doesn’t factor inflation in at all on the tax basis side of the equation. If you took a chance for your family and bought a house, took the risk of a mortgage (paid an interest rate) – why wouldn’t you be able to adjust the purchase price for inflation over the period you owned it?

The 121 deduction is beneficial compared to the old rollover rules (Section 1034) in that you don’t have to move up in value (higher price property) – you just have the exclusion on the gain. Code Section 1034 really forced taking on more risk (more house/more debt) when you sold to avoid taxation so in some ways S. 121 is better than what we had. Nevertheless, it isn’t enough in a lot of geographic areas which have seen dramatic property price increases.

Local Tax Side: The discussion on “homestead” exemptions and maximum caps on real estate tax increases very much varies depending on your state and local laws so be informed. In Florida, the “basis” for taxation of real estate taxes are set when you buy and as long you maintain your residence here, you have caps on what the annual increase in the assessed value can be. IE they can’t assess your house in year 1 at $150,000 and then bump it up in year five to $500,000 or so. It’s a fair, graduated system. However, the cap isn’t fully portable. In California, they have Prop 19 which sets up their own rules for taxation and has some interesting bells and whistles regarding inter-generational transfers.

On the local side, my gut tells me that people need to be informed and be ready and able to move with their feet if the legal status/situation changes. It is important to vote and be engaged on any changes or proposals to taxation come up. Get ahead of any potential changes. The other point is that these annual taxes generally benefit you directly (In Florida we get a detailed breakdown of where the money is being spent) so the cost is somewhat bearable or at least you have some input on it.

Summary: We don’t really have a tax policy which accurately grants individuals certain rights related to the disposition of their primary residence. If we stick to the Section 121 approach, at least the basis or purchase price, including improvements, should be adjusted for inflation, if not a higher amount because housing prices have had higher inflation costs, especially new build, in the last 20-30 years. By not granting a basis increase, you are giving a little tax benefit from the 121 exclusions, but you are making the homeowner (risk-taker, grandmother, father, parent, yourself), pay tax on the excess of what is a relatively small amount compared to housing costs in most of the major metropolitan areas.