Keeping Capital Gains Tax-Free

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NEW YORK -- Three years ago Congress gave homeowners an extraordinary gift -- the ability to shield from taxation as much as $500,000 in profit from the sale of a primary residence. But the gift is of little use to homeowners who wish to continue living in their homes and leave them to their children when they die.

Such people, estate-planning specialists say, may increase the likelihood that their estates will be subject to state and federal inheritance taxes because the property would be included in the estate of the last spouse to die. Under current law, estates of more than $675,000 would be subject to such taxes.

The estate-planning specialists say, however, that some homeowners may be able to take advantage of the capital gains tax exclusion by using what is called a "sale and leaseback." With such a transaction, they would sell their primary residence to their children -- thereby eliminating exposure of the asset to state and federal estate taxes -- while continuing to live in the property until they die.

Ralph Engel, a Manhattan estate-planning lawyer, said "it makes sense for homeowners to take full advantage of the capital gains tax exclusion whenever possible."

He explained that under current law, an individual who has owned and lived in a home for at least two of the five years preceding the sale of the home is allowed to exclude up to $250,000 in profits from taxes; the exclusion is $500,000 for a married couple. And since many states follow federal law for capital gains tax purposes, similar exclusions would likely apply on the state level as well.

For example, Engel said, if a house bought for $200,000 is now worth $700,000, the owners would have a potential capital gain of $500,000. If the owners are a married couple who use the house as a principal residence, he said, they could sell the home without having to pay federal and, in most cases, state capital gains taxes.

But, says Gary Schatsky, a Manhattan lawyer and financial adviser, "there are many empty-nesters who have no desire to downsize. Just the thought of moving could itself be enough to keep some people from selling." Those who wish to keep their house until they die, of course, increase the chance that their estate will be subject to inheritance taxes.

Schatsky explained that under current law, individuals are allowed to transfer out of their names up to $675,000 to others during a lifetime -- either as gifts while they are alive or through their estate -- before being subject to federal gift and estate taxes. (He added that the amount will increase to $700,000 in 2002 and to $1 million in 2006. He also said that individuals are also permitted to make gifts of up to $10,000 a year to as many people as they want without reducing the lifetime exclusion, currently $675,000.)

Accordingly, he said, if the last surviving spouse with the $700,000 house were to die today, $25,000 of that person's estate, plus any other assets that the person died owning, would be subject to state and federal estate taxes. …