With Great Gains, Come Great (Tax) Obligations

Let's Face It: You're likely to gain value with San Francisco real estate. Here's what happens when you sell your own home, your investment property and your parents' property

San Francisco property values have consistently appreciated at a greater rate than inflation. Instead of a modest 3 or 4 percent growth rate like you’d otherwise realize nationally, we instead talk about 7 percent annually with folks regularly realizing 30–40 percent gains. The 30-year trend for annual appreciation rates for the City is something in the 7 percent range. Selling a property in San Francisco is likely to have consequential tax implications.

Sellers usually have two questions when they think about selling:

  • “Where will I go next?”
  • “Taxes. How much will I have to pay?” and, “what can I do to minimize the burden?”

Putting aside the big issue of what a post-tax, net budget will get you in San Francisco, some sellers reject the idea of selling altogether because of considerable capital gains tax obligations that a sale would impose on sellers — an average of 37% or more. This runs the legitimate (and demonstrable) risk of distorting the marketplace as folks refrain from selling out of fear of having to pay large sums of capital gains taxes and/or out of fear of losing a low property tax assessment basis as guaranteed by California’s Prop 13. More on that later. For now, know that the Tax Code and other propositions can be used to minimize various tax obligations.

Take note: while we field a lot questions about what kinds of taxes or exclusions apply property sale, we are not tax professionals. Yes, we’ve seen enough examples of what happens when a property is sold to give our clients a general sense of what could happen with a sale. Hiring a qualified CPA and/or qualified estate attorney is critical so don’t overlook this step; it’s something that is well worth the cost given the host of issues and questions that will arise.

Here’s the good news: if you are selling your personal primary residence — well, at least one of a possible two primary residences — it’s possible that a big portion your gains will be tax-free. This depends on a few criteria below. But because we’re San Francisco and because it is also home to some of the most valuable real estate in the country, it’s more likely that a lot of your gains will also be taxable — just how much depends on your circumstances and what you’ve done during your ownership. But for owners of investment properties there are other devices that will delay when you pay those taxes that may also wipe out tax obligations for your heirs.

If You Didn't Think San Francisco Real Estate Was a Good Long-Term Investment, Look Below.

Here's An Example...

For illustrative purposes only. Actual numbers and items will vary and will depend on your circumstances.

Initial Matters First… Your Initial Basis and Adjustments to It

Okay, so how are those numbers crunched? Roughly speaking the IRS and FTB will compare three numbers to determine if you have tax obligations when you sell your primary residence. Those are: (1) your home’s initial purchase price (your “Initial Basis”); (2) your home’s final sale price; and, (3) any ‘adjustments’ that get added to your home’s Initial Basis — that number is called the “Adjusted Basis.” The bean counters will take your home’s final sale price and subtract the Adjusted Basis to determine your gain.

Next: The Marriage Deduction

While a single taxpayer may exclude up to $250,000 of gains realized on the sale of a principal residence, Uncle Sam and company like it when folks who are married, domestic partners or otherwise joint owners, sell their homes. So instead of a tax penalty we see when people are married, Uncle Sam may give an increased exclusion amount of up to $500,000 for hitched folks before taxes on capital gains kick in. In both cases, tax rates on gains above a given exclusion amount average out to be 35-40%. But don’t forget that these are the tax people we’re talking about, so there are lots of potentially complicated exceptions and caveats that may apply (i.e., consult your CPA). Here, the $250,000/$500,000 exclusions may come about only if a taxpayer (or taxpayers) owned and used the property as their principal residence for at least two years during the five-year period before the home’s sale. (Take note that the time requirement isn’t continuous and there are cases where the 2-year rule gets adjusted). Oh, one more thing: if your property is a rental property (or part of your property is a rental) you’ll have an entirely different set of rules that apply that we won’t go into here.

What’s Prop 13 Anyway?

In June 1978, California voters overwhelmingly approved Proposition 13, the infamous property tax limitation initiative that rolled back most local real property, or real estate, assessments to 1975 market value levels, limited the property tax rate to 1 percent plus the rate  necessary to fund local voter-approved bonded indebtedness, and limited future property tax increases to just a 2 percent maximum.

After Proposition 13, county property tax revenues dropped from $10.3 billion in 1977-78 to $5.04 billion in 1978-79. As a result, many local governments faced fiscal crisis requiring a bailout.

Under Proposition 13, similar properties can have substantially different assessed values based solely on the  dates the properties were purchased. Disparities result wherever significant appreciation in property values has occurred over time. Longtime property owners, whose assessed values generally may not be increased more than 2 percent per year, tend to have markedly lower tax liability than recent purchasers, whose assessed values tend to approximate market levels.

More Permitted ‘Adjustments’

You’ll get credit for remodeling, but not for repairs — that’s progress for ya

On top of the mortgage interest deductions homeowners should be taking while they own a home, homeowners may get credited for home improvements to their property. So, if you ‘improved’ your property during your stewardship you can add the costs of these improvements to raise the property’s Adjusted Basis figure. The IRS has said that “improvements” are different than “repairs.” Improvements are supposed to add value to your home and usually includes:

  • Bed, bath and garage additions;
  • New internal systems like heating, cooling, ducting, electrical, plumbing, and water heaters;
  • New exterior elements like fences, roofs, siding, windows, insulation;
  • Kitchen modernization (flooring and built-in appliances); and
  • Other items like new floors, walls, lighting, hardware, new fireplaces among more.

So long as the work is not a repair of an existing system then you’re raising the value of the property (so, why keep that old clunky water heater? It’s time to go tankless baby!)  The good thing about these remodeling boosts is that all of these types of improvements are also things that can raise a property’s sale price significantly — if done properly and smartly of course (which is where we can advise). We’ve seen that it’s usually the case that the dollars spent on remodeling will yield a far greater return on a home’s ultimate sale price, which makes remodeling an even smarter investment.

Sale Cost Adjustments

Commissions, Legal and Escrow Fees

The actual administrative costs relating to a property sale (not to mention our commissions) are last major category of ‘adjustments’ that can be added to a property’s Initial Basis and Adjusted Basis that are actually allowable costs. These costs usually include certain types of selling costs like agent commissions, legal, escrow and title fees, transfer taxes and any costs you may have paid when your bought your house that a seller would otherwise pay (e.g., there are the rare times when buyers pay the agent commissions).

By the Good Graces of Your Escrow Company

And while not an explicitly stated benefit, when a property’s sale closes escrow, the title company handling the transaction will simply distribute net sale proceeds in a lump sum. But what the title company won’t do is to withhold any capital gains taxes because they will have no idea of what’s what (the title company will pay off your property taxes from your sale proceeds however). Therefore, it’s up to a seller to figure out, file and pay any amounts due, which are only payable when they file their regular taxes as the title company will report the sale to the relevant authorities by asking you how to complete an IRS 1099-S form so they can issue a W-9 form which only the reports sales price (note things will be very different if you’re selling an income property). So if you sell in January 2016, any capital gains taxes would be due in April 2017 along with a taxpayer’s 2016 income taxes for example.

California Give-Aways

You may get to keep your current property tax rate and basis at your next house or give it to your kids or grandkids — how nice of you!

There are a few more intergenerational benefits California affords to folks 55 or older. Propositions 60 and 90 allow senior citizens to transfer the property tax basis from their current home (Home A) to a replacement home (Home B) located within the same county (Prop 60) or between certain counties (Prop 90 — you can leave San Francisco county but you cannot come into it).

This matters because Prop 13 caps property tax rate increases to no more than 2% per year (as based on your initial purchase price). The specifics are that you’ll get to bring Home A’s assessment basis amount along with you if you — or your spouse — are age 55 or older and you sell Home A and buy Home B within 1 year. Home B’s closing price can be no more than 105% of Home A’s sale price. But if you can’t find the Home B within a year of selling Home B fear not as you get 110% of Home A’s value if you buy Home B within 2 years of Home A’s sale.

And last, in case you’re in a generous mood, parents can transfer their property to their children or even to their grandchildren and still preserve the property’s current assessed value under Propositions 58 and 193 with exceptions of course.

Complicated, eh? Now you see why accountants are so busy this time of year? Give them a hug next time you see them.

L I F E  &  D E A T H

What About Estate Taxes/Capital Gains/or If I Inherit Property?

Capital Gains + Stepped-Up Adjusted Basis + Trusts = ?!?

So this applies for folks who own an income property or change the character of their property….

Application: What Happens If… Or….

Marriage, death, taxes, estates, trusts and the IRS all interplay with life changes take place of course. The stakes are much higher when San Francisco real estate is involved.

As we saw above when you own property long enough it will appreciate and gain in value by appreciation and/or market gains — especially in San Francisco. These gains are known as capital gains and are calculated on your property’s adjusted tax basis (generally based on the original price, improvements and other qualifying costs/events). Combined capital gains tax rates are now approximately 37% in California (9.8% California tax, capital gains of 20% + Obamacare tax 3.8%).

And, If a property is your personal and primary residence you are generally entitled tax exemptions of $250,000 for single filers or $500,000 for joint filers under IRS Code sec. 121. But if a property’s character is something other than primary residence — say a rental or commercial property — then capital gains tax obligations start from the property’s initial basis plus some adjustments but taxes start immediately at a property’s fair market value or contract price plus the IRS will take back at least 25% of any depreciation you’ve taken on the property too. That can add up. So what can you do?  One method that works is to defer capital gains obligations by placing proceedsinto an investment arrangement most commonly known as a 1031 tax exchange.  


Enter the Estate Tax

For anyone inheriting property who is not a surviving spouse,  estate tax issues will only kick-in if estate’s value is over $5.25M (give or take) at an effective rate of 40% for any amounts over that $5M figure. So there’s that to worry about.

In terms of estate planning, the most practical issue most people really ever encounter in San Francisco is avoiding court probate proceedings, which are costly, time-consuming and burdensome. They’re public and prolonged. To avoid this, it’s usually advisable to have some kind of estate planning device in place. Usually people will deed a property into a revocable trust. (In most cases, transfer tax obligations are moot as this is a commonplace occurrence , but check aboutpotential  mortgage issues); so, if all the ownership interests are tracked and remain the same after a transfer, no transfer tax should be triggered. (Note: usually, adding folks on to title is less of a concern than removing people named on the mortgage). So let’s put this all together:

How Many San Franciscans use Revocable Trusts Work in Real Estate

Question: What Happens When One Spouse Dies Before the Other?

Michelle and Obama are husband and wife in California. They marry here and jointly buy a home. They are subject to the state’s community property laws. They buy a house together for $400,000, which ‘belongs’ to the ‘community’ their marriage created. This means that each is entitled to will 1/2 of the community’s assets to anyone they want when each dies.

Outcome 1: House Becomes Joint Tenancy

So, Michelle leaves Obama her interest over the entire estate as is the usual practice; surviving spouse gets the other person’s share. But let’s say Obama willed his 1/2 to Hillary and dies before Michelle. Hillary and Michelle will then become Joint Tenants who own the house.

Outcome 2: House Placed into Trust

Michelle and Obama will their shares to each other. They have a son. Bill. They create a living trust to benefit Bill. The property is transferred into the trust by a quitclaim deed by Michelle and Obama. No transfer tax triggered.  But what matters here is that Obama and  Michelle’s surviving heirs can bypass court probate proceedings. If only as will existed, probate is required.  Via the trust, her heirs can skip these proceedings, which will save anywhere from $30,000 to $40,000 in legal fees and court costs.  But if the trust documents are vague or if the heirs disagree, then a court’s involvement is required. Another benefit of a trust is non-disclosure of trust terms.

Outcome 3: Probate Sale Needed

Eventually both Michelle and Obama pass away, the house then goes to whomever the beneficiaries are to their trust. At that point the beneficiaries need to decide what to do with estate property. Suppose Bill and Hillary disagree as to what to do with the estate’s property, or suppose the estate owes a lot of money to creditors. In either case a judicially-supervised sale is required under the auspices of Obama and Michelle’s trust or a judicially-created constructive trust. The house is put on the market. Depending on how the trust was created or if Bill and Hillary are in disagreement there may court confirmation required. (See Previous).

A New Generation, A New Basis: Capital Gains Tax v. 2.0  — A Step Up

Let’s say Bill receives the house and he gets $1.4M for it on the open market having not lived there during the past 5 years. What taxes does he need to pay?  Capital gains taxes apply and the house is now a long-term capital gain. Here, Bill has a $1.0M gain, right? Does he have to pay $0 or $370,000? In most cases, Bill will benefit from a new stepped-up basis that is based on the property’s fair market value on the date of the last owner’s death, here, $1.4M. Therefore, $1.4M basis = $1.4M sale = $0 gain, $0 tax liability. (If the estate is worth more than $5.25M then estate tax obligations may apply.) If he sells the property for more than $1.4M then he’ll have to pay capital gains on anything over $1.4M.

You can see it gets complicated fast, which is why you should consult a tax professional, a tax lawyer and/or an estate planning lawyer.