Quarterly Newsletters

June 2012: Taxing Your House

Many of the people with whom I meet are still confused about the taxability of the profit they realize upon the sale of their house. A surprising number of people continue to believe that the gain that is realized upon the sale of their house is not taxable if they purchase another house of equal or greater value with the proceeds realized from the sale.

In other words, if they sell one house and use the money from the sale to buy another house, the gain they realize on the sale isn't taxable. The fact of the matter is, this hasn't been the law since around 1997.

When a person purchases a house, the price he pays for the house is called his "basis." If he makes capital improvements to his home, the amount he pays for those capital improvements increases his basis. So, for instance, if he pays $100,000 for a house and makes $50,000 in capital improvement to the house, then his basis is $150,000.

An individual is only potentially taxed when he sells an asset, such as a house, for a price that is above his basis in the property. The difference between the sales price and the basis on the sale of an asset is called the realized gain.

For instance, if Mr. Smith sells his house with a basis of $150,000 for $200,000, then he has a realized gain of $50,000.

In most instances, when a person sells an asset and has a realized gain, he pays capital gains tax on that realized gain. He pays long-term capital gains tax if he owns the property for one year or more before he sells it. He pays short-term capital gains tax when he owns the property for less than one year before he sells it.

Long-term capital gains are typically taxed at a lower rate than short-term capital gains. Long-term gains are typically taxed at a rate of 15% while short-term capital gains are taxed at ordinary income tax rates. The tax code is designed to favor individuals who hold onto assets for longer periods of time.

A house receives special tax treatment. In the past, the realized gain from the sale of a primary principal residence was not subject to taxation if the person rolled over the proceeds from the sale into a new house.

Many years ago, that law changed. Today, an individual is not taxed on the first $250,000 realized on the sale of his primary principal residence if he owns and lives in the house for two of the last five years prior to the sale. A married couple can shelter $500,000 on the sale of their primary principal residence.

The individual must own the home for two of the last five years prior to the sale to qualify for the exemption. He also must live in the home for two of the last five years. Finally, the house must have served as his primary principal residence. An individual could have many houses, but only one house could serve as his primary principal residence.

Many of my clients move out of their homes because they need to reside in a long-term care facility such as a nursing home or assisted living residence. Sometimes, the children don't want to sell the house because they are uncertain whether their mother will return to live at home or not.

As long as the parent lived and owned the home for two of the last five years prior to sale, the parent can still claim the $250,000 exemption from tax. So, for instance, if Mrs. Smith lives in a nursing home for two years before her children sell her home, Mrs. Smith can still claim the $250,000 exclusion from the gain on the sale of her home because she would have owned and lived in the home for two of the last five years prior to its sale.

The "roll over" rule no longer exists. It was replaced with the $250,000/$500,000 exclusion from gain many years ago.

A SPECIAL TRUST

A recent decision of the United States Court of Appeals for the Eight Circuit, the federal appellate court that handles appeals for North Dakota, recently decided a case that highlights the use of special needs trusts and Medicaid eligibility. The case is entitled Centers for Special Needs Trust Administration versus Carol K. Olson. I'll call it the "Centers Case."

Medicaid is a federal and state cooperative program that provides medical assistance to needy individuals. The federal government has promulgated a comprehensive set of statutes, called the Medicaid Act, that govern the Medicaid program. States are free to implement their respective Medicaid programs within the confines of the Medicaid Act. In many instances, when a state violates the federal Medicaid Act, an individual can sue in federal court for relief from the state's improper actions.

In order to qualify for Medicaid benefits, an individual must have a limited amount of resources and insufficient income to pay for his care. If an individual qualifies for Medicaid, Medicaid provides health insurance; however, unlike most policies of health insurance, Medicaid will pay for the costs of long-term care, such as care in a nursing home.

Because Medicaid is for needy individuals who have limited resources and income, Medicaid punishes individuals who give away their assets in order to qualify for benefits. The manner in which Medicaid punishes an individual for having given away assets is by making the individual ineligible for benefits for a period of time. The greater the dollar value of the assets that an individual gives away, the longer the period of ineligibility.

Only transfers made during a specified period of time, called the "lookback period," are subject to being punished. The lookback period is currently five years. So, only if the applicant gave away assets within the five-year period prior to applying for benefits will he be subject to a penalty period, or period of ineligibility for Medicaid benefits.

There are certain exceptions to the transfer of asset rules. For instance, an applicant can transfer an unlimited amount of assets to his disabled child without being subject to a penalty period. An individual can give his home away to a caregiver child, a child who lived with the applicant for a period of two years prior to applying for benefits and who provided a level of care to the applicant that permitted the applicant to live in his home for those two years instead of in a nursing home.

An applicant can also transfer his assets to certain types of trusts for his own benefit without being subject to a penalty. Two of these trusts are called "special needs trusts." One trust exception is a self-settled special needs trust and the other trust exception is called a pooled special needs trust.

A self-settled special needs trust is a trust into which a disabled individual under the age of 65 places his assets. The person must be under age 65 and he must be disabled in order for the transfer to the self-settled special needs trust to be exempt from the transfer of asset penalty rules.

A pooled special needs trust is a trust that is established and administered by a non-profit organization for the benefit of a disabled individual. The trust is established for as many people who place their assets with the non-profit organization. The money is pooled together for investment purposes; however, separate accounts are maintained for each beneficiary. Unlike the self-settled special needs trust statute, the pooled trust statute says nothing about the disabled individual being under the age of 65 when the trust is established.

The Centers Case involved a pooled special needs trust. The plaintiff in the Centers Case transferred his assets into the pooled trust when he was 78 years old. He argued that because the statute says nothing about being younger than 65, he was permitted to make the transfer without penalty.

The Court ruled against him. The Court held that other provisions of the Medicaid Act say that the only transfers to trusts that are not subject to punish are those involving individuals under the age of 65, so the transfer to a pooled trust must be when the individual is under 65 to be exempt.

What do I think? I think it's a close call, and I think close calls tend to go to the state, so I can't say the Court got it wrong. Nonetheless, special needs trust can be very helpful tools for disabled people to qualify for Medicaid benefits.

EXTENDING A HELPING HAND

The Medicaid program in New Jersey is about to change for the better. Soon individuals with "high" income will be permitted to qualify for long-term care services at home or in an assisted living residence. This change has been sought for over a decade.

Medicaid is a government-sponsored health insurance program for needy individuals. Unlike most policies of health insurance, Medicaid will pay for the costs of long-term care, such as care in a nursing home or assisted living residence.

In order to qualify for Medicaid in New Jersey, an individual must have a very limited amount of resources, $4,000 being the upper limit. In Medicaid parlance, "resources" are what we typically think of as assets, such as bank accounts, stocks, bonds, and mutual funds.

If an individual needs long-term care for an extended period of time, he will spend down his assets and find himself below the resource limit. As an alternative to simply spending his assets, the individual could contact an elder law attorney and plan for Medicaid eligibility, preserving a portion of his resources.

Resources are not, however, the only part of the Medicaid-eligibility equation. An individual also must have a limited amount of income. For one program of Medicaid, the individual's gross income cannot exceed $2,094 a month. If the individual's income is one penny above $2,094 a month, he will not qualify for Medicaid.

This $2,094 a month limit is called an "income cap." Currently, in order to qualify for Medicaid long-term care services in an assisted living residence or at home, an applicant's income must be below the income cap. (The Medicaid income cap program has a $2,000 resource limit.)

There is another program of Medicaid that provides long-term care services under which an individual's income can exceed the income cap; however, this program of Medicaid currently does not pay for care in an assisted living residence or at home. This program of Medicaid will only pay for long-term care services being provided in a nursing home. (For this program, the applicant can have resources totaling $4,000.)

So, if an applicant is at home and has gross income of $2,100, he would not qualify for Medicaid; he would only qualify for Medicaid if he moved into a nursing home. If the same applicant had income of $1,900 a month, he would qualify for Medicaid long-term care services at home, in an assisted living residence, or in a nursing home.

There is a certain level of unfairness about this arrangement. A person whose income is $2,100 a month is barely more capable of paying his $6,500 monthly assisted living residence bill than a person whose income is $1,900 a month.

My understanding is that this will soon change, and the New Jersey Medicaid program will permit individuals whose income exceeds the income cap to qualify for Medicaid long-term care services at home or in an assisted living residence. As with the current program of Medicaid under which an individual's income exceeds the income cap, the beneficiary will have to "spend down" his income every month before qualifying for Medicaid.

Spending down one's income simply means that the Medicaid beneficiary is responsible for using his income every month before Medicaid will provide assistance. Assume that Mr. Smith has income of $3,500 a month and his assisted living residence bill is $6,500. Mr. Smith will have to use his income to pay the assisted living residence first, then Medicaid will pay the facility the remainder of the bill, based upon the Medicaid reimbursement rate.

From a practical standpoint, Mr. Smith's experience will be no different than a resident in the same facility with only $1,900 in income, but technically, this is what Mr. Smith will experience every month.

I commend New Jersey for opening up its Medicaid program to more individuals who desperately need the help.

BASIC ESTATE PLANNING DOCUMENTS

Over the years, I've written many articles about why a person should have a financial power of attorney, living will, and last will and testament. These three documents are the fundamental estate planning documents. It is fairly safe to say that every person over the age of eighteen should have these three documents.

Do I think everyone over the age of eighteen has these three documents? No. In fact, I'm fairly certain, based upon my experience and statistics that I have seen, that the majority of people do not have these documents.

But why do I say that most people should have these documents and what are the consequences of not having one or all of these documents? In this article, I'll explore some basic scenarios that could happen to you, as I can assure you that these scenarios happen to some other person every day of the week.

Assume that Mr. Smith is married. He and his wife, Mrs. Smith, have two children. Mr. Smith is seventy-five years of age. Mr. Smith has never signed a power of attorney, a living will, or a Will. Mr. Smith suffers a debilitating stroke. He is no longer capable of making decisions on his own.

Mr. and Mrs. Smith own their house together. The Smiths own various bank and brokerage accounts jointly. Mr. Smith has an individual retirement account in his name alone, and this account constitutes most of the couple's "liquid" assets.

Mr. Smith requires care in a nursing home. The nursing home will cost him $10,000 a month.

Since Mr. Smith has never signed a financial power of attorney, Mrs. Smith will be unable to access Mr. Smith's IRA. Mr. Smith, not Mrs. Smith, owns the IRA, so only Mr. Smith can access this account, absent a financial power of attorney given in favor of someone else, such as Mrs. Smith.

Mrs. Smith cannot do anything with the couple's house. She cannot sell the house, she cannot mortgage the house, she cannot transfer the house to herself. Although the couple owns the house jointly, one owner of real property cannot do anything with the property unless the co-owners consents. Since Mr. Smith is incapacitated, he cannot consent to any change to the ownership of the house.

This leaves Mrs. Smith with the joint bank accounts to pay the nursing home and her household bills. As the joint owner, Mrs. Smith can access the joint bank accounts. But how long are the bank accounts going to hold out given the fact that Mrs. Smith is now not only paying her household bills, which have only changed slightly to the downside since Mr. Smith began residing in a nursing home, but she must also pay $10,000 a month to the nursing home. At, let's say, $12,500 a month in expenses, the joint bank accounts are not going to last very long.

Mrs. Smith will have to become Mr. Smith's guardian. A guardianship is a court procedure through which Mrs. Smith will be appointed by the court to make decisions for Mr. Smith. A well-drafted power of attorney might cost you $200. A guardianship will cost Mrs. Smith $5,000.

What if Mrs. Smith wants to access information regarding Mr. Smith's medical condition from the hospital, a doctor, or an insurance company? Mr. Smith never signed a living will.

In 2003, a law called the Health Insurance Portability and Accountability Act, or HIPAA, became effective. HIPAA prevents doctors, hospitals, and insurance companies from sharing your health care information with anyone other than you or your designated personal representative. Since Mr. Smith never signed a living will, Mrs. Smith is not his personal representative.

Finally, if Mr. Smith passes away, Mrs. Smith will need to pay for and post a probate bond since Mr. Smith died without a Will. Mrs. Smith also will not receive all of Mr. Smith's estate. A portion of the estate will pass to their children since Mr. Smith did not have a Will. Mrs. Smith may not be pleased with these facts.

A GUIDE TO NEW JERSEY'S DEATH TAXES

As an elder law attorney, I am always surprised that no one ever talks about New Jersey's death taxes. We hear a lot about the federal estate tax, comparatively-speaking, but very little about the New Jersey death taxes.

New Jersey has two death taxes-the estate tax and the inheritance tax. Many states, such as Florida, have no death tax at all. The New Jersey estate tax, like the federal estate tax, is a tax on the gross value of the estate. If a decedent's estate exceeds $675,000, then his estate is subject to New Jersey estate tax.

The gross estate includes all of the assets that the decedent owned at the time of his death, including the death benefit of any life insurance policies that he owned. Most people do not believe that the death benefit of life insurance is included for purposes of calculating a death tax. One reason for this is that they have been told that life insurance isn't taxable.

Life insurance isn't taxable, in most instances, for income tax purposes. But life insurance is very much includible in a decedent's estate for estate tax purposes.

Furthermore, many people think that the gross estate only includes probate assets. "Probate assets" are assets that the decedent's last will and testament controls. Accounts with beneficiary designations would not be probate assets because the beneficiary designation, not the decedent's last will and testament, would control who receives the asset.

But what controls how an asset passes after a person dies-his Will or a beneficiary designation-has nothing to do with whether or not the asset was owned by the decedent at the time of his death and nothing to do with whether or not it is includible in his estate for estate tax purposes. (I will discuss inheritance tax issues in a moment.)

Think of it this way, if having a beneficiary designation on an asset prevented it from being taxed, the government would pass a law the next day simply including assets with beneficiary designation in the gross estate. It's so simple that it's rather silly and it's rather silly because it's simply a myth.

The exemption amount, $675,000, is quite low. If a person dies with a house, a brokerage account, and some life insurance, his estate could easily exceed $675,000 and be subject to the New Jersey estate tax.

If a person dies and leaves his estate to his spouse, there is no tax because a surviving spouse is exempt from the estate tax; however, without proper planning, which goes outside the scope of this article, the children of the couple may unnecessarily pay tax when the wife dies.

New Jersey inheritance tax is a tax primarily based on the relationship of the person to whom you leave your estate. There are four "classes" of beneficiaries-A, C, D, and E.

Class A beneficiaries are the surviving spouse, children, grandchildren, and parents. Because most often a person's beneficiaries are people who fall into these categories, most estates do not pay inheritance tax or have to file an inheritance tax return.

Class C beneficiaries are siblings and son-/daughter-in-laws. These individuals receive a $25,000 exemption. After that, they pay inheritance tax at rates between 11% and 15%.

Class E beneficiaries are charities and New Jersey government entities. These organizations pay no tax but the decedent's estate must file an inheritance tax return.

Class D beneficiaries are all other possible beneficiaries. They pay tax at rates between 15% and 16% on everything they receive if they receive more than $499.

All assets of which the decedent died owning are taxed except life insurance that names a beneficiary. Unlike with estate tax, life insurance that names a beneficiary is not subject to the tax.