When Protecting Assets Beware of Capital Gains Tax (Part 2)

             Last week I told you that when protecting assets from the cost of long term care or from an estate tax when you pass away, there is another tax – capital gains tax – to be aware of and I explained how the tax is calculated.  This week let’s look at a few more terms that will help you understand the capital gains tax problem.

            There is something called the personal residence exclusion.  You may exclude up to $250,000 of gain on the sale of your personal residence from tax and if married up to $500,000 of gain.  To qualify, you (or your spouse) must have lived in and owned the house for at least two of the five years prior to the sale.  Those years do not need to be consecutive.

            Another term you need to understand is a carry over basis.  If you give property to someone else, such as stock or real estate, that person receives it with your basis.  If A bought shares of a stock for $1 per share and gifts it to B, and B sells it for $10, B’s gain is $9 because he keeps A’s basis.  It “carries over” to him.

            On the other hand if B inherits that stock from A when A dies, and then B sells it for $10 he will avoid some or possibly all of the capital gains tax.  That’s because of something called a step up in basis.  B’s basis “steps up” to the value at the date of A’s death.  If the stock in our example is worth $10 at A’s death and B sells it at that price he avoids the capital gains tax entirely.

            Last week I said that the capital gains tax is often lurking in the shadows because people often don’t realize how it works and that can be a problem when doing asset protection planning.  Let’s look at a common scenario.

            Mom wants to protect her $600,000 home from being spent towards long term care or maybe she wants to reduce her estate to avoid estate tax so she transfers her home to her children.  When she dies and her children sell the home they will have to pay capital gains tax because they will get a carry over basis.  If Mom and Dad own the home for many years chances are the basis will be very low and there could be hundreds of thousands of dollars of capital gain.

            If she instead holds onto the home until she dies and the children inherit it at that time they will get a step up in basis to the value at the date of her death.  They will avoid the capital gains tax entirely if they sell the home shortly after that.  The same applies to stock.

           If Mom wants to transfer the home to avoid estate tax she should be sure that the estate tax to be saved is less than the capital gains tax her children will incur by making an outright transfer to them.  Otherwise it doesn’t make much fiscal sense to do it because she will lose the step up in basis.

          After reading this you’re probably asking yourself, “if Mom doesn’t transfer the house then how can she protect it from long term care?”  The answer is by utilizing a specific trust for this exact purpose.  I’ll share that with you next week.