As the year draws to a close, many Americans are still trying to grasp all the revisions in the tax law
that went into effect last summer as part of the Taxpayer Relief Act of 1997. One of the changes that has the most impact on homeowners is the new capital gains tax, which substantially increases the exemption for those who sell their primary residences, while also reducing the tax rate from 28 to 20 percent. For those people looking to sell their homes and take substantial profits, this is very good news. In addition, the tax savings incentive could be instrumental in spurring sales and freeing up residential inventory, good news for the real estate market which has been faced with shortages of large Manhattan apartments for sale over the past year or so.
A Winning Combination
The actual reduction in capital gains tax, from 28 to 20 percent, is fairly substantial. But it is the increase in the amount of gains that are exempt from taxes that clearly spells the advantage offered by the new law, which applies to sales after May 7, 1997. Married homeowners filing jointly can now exclude up to $500,000, and individual homeowners up to $250,000, in profit on the sale of a home that has been a primary residence for at least two of the five years preceding the sale.
Under the old law, a two-year tax deferral was allowed following the sale, after which the profits had to be reinvested in another property of equal or greater value in order to avoid capital gains taxation. So under the old law, the profits from the sale of a home were never fully realized in the long-term; they were simply shifted to another property.
There was also the once-in-a-lifetime deferral of $125,000 for those 55 years old and over. But often it barely made a dent in the appreciation of properties purchased many years before, particularly in those metropolitan areas where the market has been very strong. For example, New York City co-op shareholders who purchased their three- and four-bedroom apartments 20 years ago for $50,000 or less, often found their homes had appreciated to more than 20 times the initial sum.
A typical New York City scenario is the couple who purchased their three-bedroom West End Avenue co-op apartment in 1977 for $45,000. They raised a family in these spacious quarters, became active in the community, and enjoyed the neighborhood for 20 years. Now that the kids have grown and moved on, they have retired and are ready for a smaller, more convenient apartment. But in this boom market their home is worth $800,000, causing a tax liability that, under the old capital gains law, made selling the apartment prohibitive because the taxable income was too high. Even with the once-in-a-lifetime $125,000 deduction, they would have been responsible for paying the Federal government 28 percent of $630,000, equaling a tax of $176,400.
The available alternative under the old law was to transfer their six-figure profit into purchasing a new home. But like so many people who used their home equity to finance college tuitions, weddings, etc., they no longer have enough equity to pay the taxes, let alone purchase a $630,000 home for purposes of reinvestment. Even if they exercise another alternativepassing the estate to the childrenthis retired couple would not be able to realize the considerable profits generated from their prope ffb rty in their lifetime.
Under the new law, this couple can now deduct $500,000 from their $755,000 profit, and with the reduced tax rate of 20 percent, they are now responsible for paying $51,000 in capital gains tax; a tax savings of over $125,000! Selling becomes not only a viable alternative for those in pursuit of a more convenient lifestyle, it becomes advisable. They can now use their after-tax profit of over $700,000 to buy a two-bedroom condo in Florida for $200,000 and live on the remaining $500,000 comfortably for the rest of their lives.
There's a tremendous opportunity for owners of appreciated properties to take a tax-free profit, says Craig Schiller of Schiller & Associates, a Manhattan-based law firm. But he adds a cautious note by further advising, Those who wish to assure their gain should take advantage of the new laws now, since most tax benefits are temporary in nature and subject to change. In other words, M-get, while the going is good.'
A Downside for Some
While the new capital gains law offers great opportunities for the majority of homeownersit is particularly effective in offering tax shelters for the middle-classesit may have a negative effect on those whose properties show the greatest appreciation, since they will still have a substantial tax liability. Moreover, these affluent homeowners are additionally penalized because they no longer have the option of deferring capital gains by reinvesting in another property.
For those who stand to lose as a result of the new tax laws, attorney Elliott Meisel of Brill & Meisel recommends holding onto their properties and utilizing different devices to defer tax liability.
Setting up a Qualified Personal Residence Trust (QPRT) removes the apartment from the tax liabilities of a personal estate and provides substantial discounts, Meisel points out. Under the current Federal Gift and Estate Tax law, by transferring an apartment into this type of trust, individuals can pass on to beneficiaries a lifetime total of $600,000 in assets which will not be subject to Federal taxes. In addition, by stipulating the right to live in the apartment for ten years, the value of the asset will be subject to even more discounts as a result of depreciation from occupancy. Another device to minimize tax liability is to set up a Family Trust or Limited Liability Company (LLC).
The new capital gains tax, with its built-in liabilities for those in higher income brackets, may be successfully offset through thoughtful and conscientious estate planning. Nevertheless, the revocation of the rollover as provided in the old capital gains tax law will necessitate creative asset planning when dealing with very expensive primary residences.
There will also be those who are caught in the middle with too high a gain and not enough equity to consider totally deferring the profit on a long-term basis. A 40-plus single mother who purchased her three-bedroom Flatiron loft-style apartment at auction back in 1989 for the remarkable sum of $25,000 in cash, would now like to sell her home. In eight years, she has made substantial improvements on the space, changed careers, and even adopted a child. Now she has decided it's time to leave the city for the suburbs, so her child can have a backyard and the benefits of good public schools. But now that her apartment is worth $550,000, she has some taxes to pay.
Six months ago, she could have sold the apartment, rolled over the $525,000 profit into a new house and paid no capital gains tax. But under the new law, her tax liability, after deducting her $250,000 exclusion and $100,000 for improvements, is $35,000. Not only does this tax cut into her profits, it diminishes the ability to buy a new home of equal quality in her area of choice.
Still, a $495,000 after-tax profit is not such a terrible return on a $25,000 initial investment.
Impact on the Market
While most New York City brokers are hoping for a surge of additional apartments to hit the market, the overall outlook remains both guarded an ffb d optimistic. At this moment, it is still too soon to tell how much activity will be generated as a result of the new capital gains tax laws, says Joyce West, executive vice president of Charles H. Greenthal Residential Sales Corp. Supply and demand is still the defining equation concerning the amount of activity in New York, and despite the tremendous tax benefits available to potential sellers, they still need an alternative residence in which to live.
If their intention is to leave the cityas is the case with many empty-nestersthere is no problem; but if they choose to remain here, there is still a considerable investment to consider that may not outweigh the benefits of selling. In other words, the verdict is still out.
Kay Brover, executive vice president of Douglas Elliman, one of Manhattan's largest real estate brokerage firms, agrees. We were hoping the new law would loosen some people who were holding on to their apartments. But so far, we haven't seen an impact.
Brokers at the firm have been informing sellers about the new law in the hope that it will inspire some people to put their homes on the market.
Most people aren't aware of it, says Steven James, executive vice president and director of East Side sales at Douglas Elliman. But it will catch on when more brokers disseminate information to potential sellers.
Mark Taub, CPA, of Ellenbogen, Rubenstein, Eisdorfer & Co. LLP, believes the new capital gains tax law will be good for the economy, but has yet to see the immediate effects. We haven't seen any instant benefits, but it will probably be another six months to a year before people fully understand the new law and make decisions based upon it.
People who want to take the equity of their homes and have the benefit of extra money to live on, can now do so, says Stephen Beer of the Manhattan accounting firm Czarnowski & Beer. From a professional standpoint, tax returns will be less complicated and people will be able to do financial planning using their home equity, since they can sell every two years.
For New York City, it will hopefully translate into the increased availability of much-needed family-sized housing stock. And with the market at an all-time high, and scant new product, this is an ideal time to free up additional inventory.
One of the Best Investments
Real estate is the best hedge against inflation, and with this new law, it is a great way to minimize one's personal tax liability, says Allen Turek of Schiff, Turek, Kirschenbaum, O'Connell, LLP. We tell clients that if the co-op or condo apartment they are buying appreciates in value, and they can hold onto it for five yearsusing it as a primary residence for a minimum of two yearsit is one of the best investments available. We also recommend they get involved in creative tax planning as early as possible, in anticipation of those circumstances where appreciation will likely exceed the allowable deductions.
One example of creative planning concerns people with weekend or vacation homes. With the new law, it is possible to sell the apartment in the city and move into the vacation home for two years, then sell that too. That's double the profits on two existing residences within two years.
Douglas P. Heller of Friedman, Krauss & Zlotolow, a Manhattan-based law firm, predicts that many New York residents will be encouraged to sell. It makes sense for people to sell when they have reached a gain of $500,000. It could churn the market, because a lot of people will take advantage of the benefits.
Or, as attorney Lawrence D. Frankel of Thomas & White puts it, It's already a revved-up market and the new capital gains tax adds even more horsepower.
Ms. Chesler is executive editor of The Cooperator.
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