Question: We qualify for the $500,000 residence exclusion, but the capital gain in our home would exceed $500,000. May we shift any potential gain to our adult son?
Answer: Yes. Use your annual gift tax exclusion of $10,000 ($20,000 for husband and wife) per year, per beneficiary, to transfer an undivided interest to your son as a tenant in common. In addition, you may use a portion of your Unified Estate and Gift Tax Credit ( worth $625,000 in 1998 and increasing to $1 million in 2006) to shelter the balance of the gift tax. And if your child owns and lives in the residence for 2 of the next 5 years prior to its sale, he will qualify for the residence exclusion as well.
Example: If your home is worth $1 million and your adjusted basis is $250,000, your potential gain is $750,000. The residency exclusion applies to $500,000, leaving a taxable gain of $250,000. If you gift your child a one-third interest in the property, then his gain will be $250,000. The home may be sold after two years later for $1 million without capital gain tax to either you or your son since the capital gain on each portion will be shielded by the residence exclusion.
Your gift tax computation is tricky. Although one-third of $1 million is $333,333, you might be entitled to a fractional interest discount (assume 30%), thereby reducing the gifts value $233,333 (333,333 - 30% = $233,333). After application of the annual gift tax exclusion of $20,000, the $213,333 balance would easily be sheltered by your Unified Credit (husband and wife may each reduce their Unified Credit by $116,666.50).
Question: How do I take advantage of the residency exclusion without actually selling my house?
Answer: Borrow against the equity on your home up to $250,000 ($500,000 for husband and wife) and later repay the loan from the sales proceeds. The residency exclusion eliminates the capital gain. Note, with a home equity loan, only the interest paid on $100,000 of loan principal is tax-deductible.
For example: An individual purchases a home for $250,000 with $50,000 down and a $200,000 mortgage (deed of trust). The homes value increases to $500,000. The taxpayer then borrows $250,000 on the homes equity and spends the funds. When the home is sold for $500,000, the taxpayer repays the lenders without incurring a tax on the $250,000 profit.
Also, you may sell the remainder interest in your residence to an independent third party. When a remainder interest is sold, the purchaser acquires full rights to the home upon the death of the seller; therefore, the you may continue to live in the home during the rest of your life. The profit from the sale is tax-free up to $250,000 ($500,000 for husband and wife).
Note: You may combine a home-equity loan with making a gift to a child to minimize the gift taxes. Suppose the couple in the first example borrows $750,000 against the home, then transfers the one-third interest to their son. The sons interest is subject to the outstanding liability and he cannot sue his parents to repay his share of the liability. Under these conditions, the gift would be measured by the equity in the property transferred ($333,333 - $250,000 = $83,333 equity). After applying a fractional interest discount of 30%, the gifts value is reduced to $58,333. The annual exclusion eliminates $20,000 of the gifts value and the remaining $38,333 is sheltered by the Unified Credit (husband and wife may each reduce their Unified Credit by $19,167).
Question: My husband and I are foreign citizens. I am moving to the U.S. my myself and will purchase a home. How do I ensure that I can deduct the full mortgage from my U.S. tax returns?
Answer: You could file a joint return, but your husbands income would then have to be included. Generally, you would file as married person filing separately to exclude your husbands income from your return. For full advantage of the mortgage interest deduction, the deed and mortgage should be only in your name. Your husband should not be on title nor sign the mortgage; otherwise, the IRS might allocate a percentage of the interest deduction to him and because he has no U.S. income, his deduction will be wasted. Remember: Your interest deduction is limited to the interest paid on $1,000,000 of principal secured by your principal residence, provided the loan is used to purchase your home.
According to Emmie Yang, a San Francisco-based international financial planning expert, "If the husbands credit is necessary to qualify for the loan, he should sign a separate document guaranteeing repayment of the mortgage, rather than co-sign the mortgage. This will preserve the wifes interest deduction and satisfy the banks lending requirements."
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**