Move afoot to close home-sale tax trap

Nation's Housing

`Surviving spouse' law can prove costly

May 09, 1999|By Kenneth R. Harney

NO ONE knows how many Americans confront the costly "surviving spouse" home-sale tax trap every year. But a bipartisan group of congressmen wants to end it, now.

The trap -- really a quirk in federal tax law -- works like this: Under reforms enacted in 1997, married home sellers who file tax returns jointly may qualify for a tax-free exclusion of up to $500,000 in capital gains on their sale. Unmarried or single-filing home sellers may qualify for up to $250,000 in tax-free gains.

But what about homeowners who are married for a number of years, build up substantial equity in their homes, but suddenly find themselves single again after the death of a spouse?

Under the 1997 law, the surviving spouse can take the full $500,000 only in a joint filing for the tax year in which his or her spouse died. After that, the homeowner reverts to single-filing status, and is limited to the $250,000 maximum exclusion for singles, until he or she remarries.

Here's a hypothetical case of how this might play out.

Say Bob and Mary Preston married years ago and bought a house for $200,000 in what is now a higher-cost area of the country. Thanks to inflation, good location, and a strong economy, the home was worth $600,000 last year, when Bob died of a heart attack.

Putting aside relatively small capital improvements the Prestons made to their house, their gain o n the property would total close to $400,000 as of last year.

According to critics of the "surviving spouse" tax trap, Mary might well believe -- or be advised by a tax preparer -- that if she didn't sell in the year of Bob's death, she'd lose her ability to take the maximum tax-free exclusion in later years.

She'd be limited to a $250,000 exclusion on the $400,000 gain, and would face capital-gains tax of 20 percent on the remaining $150,000 -- $30,000 out of her pocket.

Estate tax experts say there's no reason why Mary should have to confront this dilemma in the first place.

Had she been familiar with estate tax law -- or been advised by an estate tax planner -- she would have known that at her husband's death, she was eligible to inherit his ownership share of the house at a "stepped-up basis."

Get an appraisal

That is, she could take over his 50 percent share at its market value on the day of his death -- roughly $300,000 -- provided she obtained a professional appraisal. Then her capital gains tax exposure would have been fully covered, and she would get the entire $400,000 gain, tax-free.

But critics of current law, including the author of the "Surviving Spouse Fairness Act of 1999" (HR 241), Rep. Marge Roukema, a New Jersey Republican, say many taxpayers -- and their tax preparers -- aren't familiar enough with the interactions of federal estate tax rules and the new home sale capital-gains exclusion law.

Horace B. Deets, executive director of the American Association of Retired Persons, agrees. He says "most taxpayers and some [tax] practitioners" don't properly understand how the law works in this complex area.

Deets also argues that because some married, joint-filing homeowning seniors have placed the legal title to their homes in the name of just one spouse -- and that spouse turns out to be the surviving spouse -- they lose out on the "stepped-up basis" estate tax rule.

Those spouses then find themselves owning the house as a single taxpayer, and are limited to the $250,000 maximum exclusion.

Grief and pressure

Roukema, who has assembled a group of Democratic and Republican co-sponsors for the bill, complains that widows or widowers "should not be hit with a severe tax penalty on top of the loss of their spouse."

Nor should they feel pressure to sell their longtime home within the same year their spouse passed away, or be pushed by tax law considerations to remarry.

An extreme case, said a congressional staff member familiar with the problem, might involve a longtime married couple with substantial gains in their home, where one spouse dies late in the year.

While "still in mourning," the aide said, the surviving spouse "might feel time pressure to sell the property to preserve the quarter of a million dollars that she really needs to stay afloat financially."

One tax expert said that "if people simply knew the law" -- especially the stepped-up basis estate tax interaction -- "there would be almost no problem here."

But "the fact is that it's all kind of confusing," she said, "especially for homeowners who lose a spouse suddenly and never gave a thought to tax issues."

The upshot here: We probably need to fix the law or do an educational campaign for homeowners. But fixing the law's a lot easier.

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