Your Home: 4 Tax-Smart Moves

For many people, a home is one of their most valuable assets. As such, it needs to be factored into your estate plan. Traditionally, homeowners have focused on limiting estate tax. Now, they need to shift their focus to saving on income tax. The reason: The estate tax exemption has climbed to $5.43 million per person (or $10.86 million for married couples), thereby making estate taxes less of an issue. Meanwhile, capital gains tax rates are at their highest in many years, and many people nearing or in retirement are living in homes that have increased enormously in value.

For example, assume Harry, 65, and Sally, 67, paid $300,000 many years ago for a house that's now worth $2 million. If they sell today, they would owe tax on a $1.7 million gain.

If Harry and Sally have lived in the house for at least two of the five years before the sale, they qualify for a special tax break that is available to homeowners who sell their principal residence (but not vacation homes): The first $250,000 (or $500,000 for married couples) of their gain on the sale is not subject to tax. That still leaves Harry and Sally with a taxable gain of $1.2 million. Including the 3.8% net investment income tax that took effect as a part of the Affordable Care Act, Harry and Sally would be taxed on that gain at a 23.8% rate, and owe Uncle Sam $285,600.

Various tax-saving maneuvers can help this couple--and others like them--reduce that bite.

If You Can Afford to Keep the HouseIf you leave the house to your heirs, they can avoid most, if not all, of the capital gains tax you would have to pay if you sell the house yourself. That's because with most assets, including real estate, inheritors can "step up" their tax basis to whatever an asset was worth at the original owner's death. This enables them to sell a highly appreciated home without being taxed on the gains that occurred before they inherited it.

If you need to move out of the house--say it has become unmanageable, or you want to relocate--consider renting your house. Renting would provide an income stream to help cover current living expenses--and avoid capital gains tax.

If One Spouse Is in Poor HealthBecause of health issues or a significant difference in age, sometimes you are fairly certain whether you or your spouse is more likely to die first. If your home has appreciated significantly in value, it might make sense to have it owned solely by the spouse whose death is more likely to occur first. This enables the spouse who inherits the home to take advantage of the step-up in basis.

Provided your spouse is a U.S. citizen, you can give an unlimited amount to him or her during your life or through your estate, with no tax applied--this is known as the unlimited marital deduction. If a couple owns the home jointly, the healthy (or younger) spouse ought to transfer his or her interest to the other.

One important condition applies: If your spouse transfers the assets, you die within a year, and your spouse inherits the same assets back, there is no step-up. This provision in the Internal Revenue Code prevents a healthy spouse from transferring everything to a dying spouse (with no gift tax) and getting it back with a basis step-up (and no estate tax).

In this respect, spouses have an advantage in community property states: When the first spouse dies, both halves of community property get a step-up in basis. There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Two other states, Alaska and Tennessee, also have community property, but you have to "opt in" to it, and in Tennessee the property must be held in trust.

If You Want to Become a RenterBy converting your personal residence or vacation home into a rental property, you can position yourself to do what's called a Section 1031, or like-kind, exchange, and avoid paying capital gains tax.

This strategy, named for a section of the Internal Revenue Code, involves a swap of one investment asset for another--something that would ordinarily be taxable as a sale but isn't if you meet certain conditions, says Stephen J. Small, a Boston lawyer and the author of books on preserving family lands. First, you must move out of the house and rent it for a decent period of time (more about that below). After that, if you sell the rental property and buy another one of equal or greater value, you don't have to pay capital gains tax. (If the house you're selling has a mortgage, the mortgage on the new house must be for the same or a greater amount.) Any differential creates some gain--what's called "boot"--that's generally taxed as capital gain.

Not surprisingly, those who try to get cute with the rules tend to lose their battles with the IRS, so it's best to have a tax pro to guide you through the formalities. Nor is this a strategy for the sharing economy--for instance, when people rent their homes temporarily while they travel, says Stefan F. Tucker, a lawyer with Venable in Washington, D.C. Rather, "you must be able to show it's a bona fide investment property" and no longer your personal residence. He advises clients to rent the home for at least a full calendar year and part of another (for example, from September until the following December). Likewise, the new property that you buy must also be an investment, rather than a personal residence.

If You Anticipate a High-Income YearLet's say you expect your income will be higher than usual--perhaps because you plan to sell a business, exercise employee stock options, start drawing on retirement funds, convert a traditional IRA to a Roth, or take deferred compensation. Donating your home to charity in the same year as this income spike saves capital gains tax and entitles you to a tax deduction, which can reduce what you owe. For real estate, that deduction can equal up to 30% of your adjusted gross income, and any deduction that can't be taken in the year of the donation can be carried forward up to five years.

People who want to create an income stream for themselves or family while benefiting charity might consider a FLIP unitrust, says Lawrence P. Katzenstein, a lawyer with Thompson Coburn in St. Louis. Here's how it could work, again with Harry and Sally: They put their house into a charitable remainder trust. The trustees sell the house and invest the proceeds in a diversified portfolio. Starting in the year after the sale, the trust, as provided for in the original trust document, starts paying Harry and Sally, as trust beneficiaries, annual income expressed as a percentage of the fair market value of the trust assets revalued each year; in today's investment environment, 5% would be typical, Katzenstein says. This income stream continues until both Harry and Sally have died, at which point whatever assets remain in the trust go to charity.

Because the trust is a tax-exempt entity, it doesn't pay tax when it sells the house, so Harry and Sally save the capital gains tax they would otherwise have to pay. In addition, when they make the donation to the trust, they would get a current income tax deduction for the value of the charity's remainder interest, which in their case is $702,020, says Katzenstein. The deduction is based on their ages, the number of life beneficiaries (the older you are, the larger the deduction), the value of the property, and an assumed interest rate set by the IRS. If the house is sold for $2 million and the assets, as invested, hold steady at that amount, the 5% yearly payout to Harry and Sally would be $100,000. If the value of the trust assets fluctuates, so will the dollar amount paid to Harry and Sally each year.

A few caveats apply. To steer clear of various tax law restrictions, the property that is being donated should not be mortgaged, and you must move out before putting the house in the trust. In addition, beware of what's called the pre-arranged-sale rule. It prohibits you from making a commitment to sell a noncash asset, including real estate, before giving it to charity. If you violate the rule, you must pay tax on the gain.