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Capital Gains Could Be Your Loss
Capital Gains Pitfalls of Home Transfers to Avoid Estate Recovery


By Greg Wilcox, Esq.

Usually Good Advice

It is almost always good advice to suggest that a spouse in a nursing home transfer his or her interest in the family residence to the community spouse. We all know that such a transfer does not disqualify the transferor spouse from Medi-Cal nursing home care, that it prevents the home from being exposed later to estate recovery for Medi-Cal benefits paid to the institutionalized spouse, and that it allows the community spouse full control over the property for purposes of sale or borrowing. Indeed, such home transfers are so often a good idea that the legislature has actually mandated the Department of Health Services and skilled facilities to provide applicants a specific notice that a Medi-Cal beneficiary can transfer a home without prejudicing Medi-Cal eligibility, Welf & I Code §§14006.3 and 14006.4. There is only one problem: sometimes such advice can land the community spouse (and attorney) in deep tax trouble.

In the most common cases, there won't be any problem. For example, the community spouse ordinarily will not sell the residence before his or her death. Under current federal tax law, after the community spouse's death his or her beneficiaries will take the residence with a new capital gains tax basis under IRC §1014(b)(9). But what if the community spouse wants to sell the residence before his or her death (or might be forced to sell)? In most such cases, his or her $250,000 exclusion for sale of a residence will shield the capital gains from any actual tax liability.

But what if the capital appreciation has been more than $250,000? In many areas of California, particularly in the Los Angeles and San Francisco areas, even modest homes have appreciated beyond anyone's wildest dreams. Gains of over $400,000 on a home purchased for $25,000 are not uncommon. Then there's a problem.

First Scenario

There are two scenarios after the institutionalized spouse transfers his or her interest in the residence to the community spouse: either the community spouse sells after the death of the institutionalized spouse or sells before the death of the institutionalized spouse. In both cases, because it is a gift, the donee spouse will receive a carryover basis from the donor spouse.

If the community spouse sells after the death of the institutionalized spouse, he or she will be selling as a single homeowner and will be eligible for only a $250,000 exclusion against capital gain (for sale of a residence under IRC §121(b)(1)). Normally, such a surviving spouse would be able to rely on the current IRS rule that both halves of the community property are entitled to a stepped-up tax basis (IRC §1014(b)(1), (b)(6)). He or she would then be able to sell the residence with little or no capital gain to report or pay tax on. But if the institutionalized spouse has already transferred the property to the community spouse, the property ceases to be community property and is therefore no longer entitled to a stepped-up basis on both halves (or even the decedent's half) at the date of the institutionalized spouse's death.

One way to cure, or at least reduce this problem might be to allow the institutionalized spouse to retain a right of occupancy in the residence in spite of the transfer. Doing so would allow a stepped-up basis on his or her half (under IRC §2036(a) IRC §2036(a)), and the remaining half of the appreciation might be within the survivor's $250,000 exclusion when he or she eventually sells. Although it is hard to predict the erratic actions and policies of Medi-Cal's estate recovery unit, the spouses can reasonably hope that such a retained right of occupancy will not be a sufficient interest to attract the recovery unit's attention.

Second Scenario

The second scenario is where the community spouse sells before the death of the institutionalized spouse. Again, the community spouse will be selling as a sole owner of the property, and he or she will have received the other spouse's carryover basis with the gift transfer.

In that situation, the community spouse would normally expect to use the $500,000 capital gains exclusion available to married couples filing jointly when they both own and use a residence (according to IRC §121(d)(1) and new IRS Reg. §1.121-2, TD 9030, issued Dec. 24, 2002.2002). And, in fact, the full $500,000 exclusion may be available — but only for a while. The fact that the community spouse is the only owner after the transfer does not present a problem because IRS rules say that either spouse can meet the ownership test for the couple.

So far, so good. However, the same IRS rules also say that both spouses must meet the use test in order to qualify for the $500,000 exclusion. Ordinarily, this means that both spouses must have used the property as their principal residence during at least two of the last five years. As a result, the community spouse's window of opportunity to sell his or her residence and avoid tax on capital gains over $250,000 using the $500,000 exclusion is of limited duration. It will start to run out the day the institutionalized spouse is institutionalized and no longer uses his home as a principal residence (as defined in IRS Reg. §1.121-1(b)), and be gone in three years.

Nuances

There are four nuances. First, even after the institutionalized spouse dies, the surviving spouse can still use the full $500,000 exclusion by selling during the year of death and filing a joint return with decedent's executor for the year of death pursuant to IRC §6013(a)(3) (IRS Reg. §1.121-2(b)(4)(Examples 4 and 5). If the surviving spouse waits until the next calendar year to sell, the $500,000 exclusion drops down to $250,000. Moral: spouses should always die early in the year.

There is a special "use" rule that reduces the normal two years out of five use requirement to one year out of five where the taxpayer is "incapable of self-care" (IRS Reg. §1.121-1(c)(2)(ii)). Then the IRS will count the taxpayer's residence in a nursing facility as "use" of the property as a principal residence. However, the taxpayer also has to be an "owner" of the property for this exception to apply — and our facts assume a transfer to the community spouse by the person needing such care.

There is a special hardship exception that allows a "reduced exclusion" on sale of a residence when the full ownership and use tests are not met. However, the exception requires that the sale be due to a "change of place of employment, health, or unforeseen circumstances" (Proposed and Temporary IRS Reg. §1.121-3T(b), TD9031, also issued Dec. 24, 2002). These are not likely going to be the reasons that the community spouse will eventually sell (but if they are, some of the $500,000 exclusion might be rescued).

Finally, if advisors take the advice above and arrange to have the institutionalized spouse retain a right of occupancy (for stepped-up basis after death), the community spouse may still decide to sell before the other spouse's death. Then the community spouse will have to find some way for the institutionalized spouse to convey his or her occupancy interest to the buyer. So the gift transfer to the community spouse should always include execution of a separate durable power of attorney allowing the community spouse (or someone) to transfer out the interest if the property might be sold before the death of the institutionalized spouse.

Gregory Wilcox, Esq. is an attorney in private practice in Berkeley, CA.

From the Summer 2003 Legal Network News

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