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Sunday, March 23, 2014

Selected Tax Considerations of Holding Family Real Estate Assets


How should a family residence be held by spouses? When this question is contemplated, taxes are rarely on a short or long list of things to be considered. While taxes are ever present in my professional life, I doubt that I would give much consideration to the tax side of things when answering this particular question in my personal life. But maybe I should. And here is why!

Most common way of ownership of family residences is joint tenancy or tenants by the entirety. This form of ownership is really a physical manifestation of trust and reliance spouses put in each other. This form of ownership also guarantees that the surviving spouse inherit the house upon the passing of a spouse.

There are no income tax advantages of holding family residence in a joint ownership. If spouses file a joint income tax return, interest and taxes are deductible regardless of whether the residence is owned jointly or by one of the spouses alone. The $500,000 exclusion of gain on the sale of the principal residence would also generally apply to spouses filing joint returns.

However, consider the following situation: John and Leslie have been married for many years and have two wonderful children. They own all their assets jointly, including their family residence where their children grew up. Unfortunately, Leslie passes away. The house and all other assets automatically pass to John. Several years later John remarries and places all of assets in joint ownership with his new wife. If John predeceases his new wife, all of his assets are automatically passed to her, leaving nothing to John and Leslie’s children.

John and Leslie’s problem can easily be solved by drafting a will and by utilization of a QTIP trust. Placing a residence in a QTIP trust would shield John and Leslie’s house from estate taxes, as unlimited marital deduction would still apply and would allow John, in our example, to live in his house for the rest of his life. Upon John’s demise, the house could pass to John and Leslie’s children. Remember, a trust is essentially a contract and could allow for great flexibility in its operation. The trust can provide, for example, that John can encumber the property with a reverse mortgage if he needs the money to live on. The trust document can prohibit or permit its sale, or limit the amount of additional mortgage John can place on the property.

A lot of other pros and cons must be considered before utilizing this technique, but at a very least, it would be prudent for spouses to have a conversation about it.

Divorce Planning – Watch Out For Carry-over
All transfers of property between a husband and a wife that are “incident to the divorce” are subject to non-recognition treatment under the Internal Revenue Code. In essence, the transfer is treated as a gift from one spouse to another. The transferee spouse takes a carryover basis (i. e. basis stays the same) in the property and he or she recognizes no income upon receipt.

Consider the following situation: The Husband and The Wife own two pieces of investment property each valued at $1 million. Property One was acquired a while ago for $100,000 and Property Two was acquired last year for $950,000. The spouses have an amicable divorce and quickly agree on a fair 50/50 split. The Husband takes Property Two and The Wife takes Property One. Each spouse ended up with a property valued at $1 million. Fair, right? Well, not really.

Let’s say that each of the spouses decided to sell their respective property. Wife sells her property for $1 million. The transaction results in $900,000 taxable gain ($1 million sales price minus $100,000 carryover basis). Assuming that a combined Federal capital gain rate and a state income tax rate is 30%, Wife’s after tax proceeds are $730,000 ($1 million amount realized less $270,000 tax liability as a result of $900,000 gain).

However, when the Husband sells Property Two for that exact $1 million, his taxable gain is only $50,000 ($1 million sales price less carry over basis of $950,000). Therefore, applying the same tax rate, his after tax proceeds are $985,000 ($1 million amount realized less $15,000 income tax bill generated as a result of the sale).

Hence, even though each of the spouses would end up with a “fair” 50/50 value split of their investment properties, the Husband in our example would end up with $255,000 more in cash. For one reason or another, the spouses may still decide to split the assets this way, but just in the case of joint ownership, they should do so with their eyes wide open.

Tax Reform Update: Real Estate

  • The deferral of gain on like-kind exchanges would be repealed.
  • The low income housing credit would be modified, extending the credit period from 10 to 15 years, and by repealing the 4% credit (but keeping the 9% credit).
  • There would be a mandatory basis adjustment in partnership assets when a partner transfers a partnership interest.
  • The “technical termination” rule would be repealed.

A “carried interest” would be partly taxed as ordinary income, and partly as capital gain based on a formula.

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