$125,000 Exclusion: The Law Is Perfectly Clear

Q: I am 86 years old and have been renting out my house in Northern California since moving in with my second wife in Southern California 12 years ago. I would like to sell the house and take advantage of the $125,000 one-time profit exclusion available to senior citizens.

Is there any way for me to legally claim that house as my residence without actually living there year around? --C.F.D.

A: The law is quite clear about the requirements for qualifying for the $125,000 exclusion. You must be at least age 55 and the home in question must have been your principal residence for three of the last five years. The law allows no exceptions, no matter how compelling the taxpayer’s story.

From what you have related, it would appear that you do not meet the test. And even if you resort to an elaborate and expensive illusion to trick Uncle Sam, it is doubtful that you could meet the test. It’s also questionable why, at your age, you would want to.

First, let’s examine what you might have to do to fool Uncle Sam into thinking that you are really living somewhere that you’re not. For starters, you’d have to get rid of your tenants and say goodby to that rental income. Then you should start using that address as though you really live there. Your driver’s license should carry that address. Your bank should be nearby and your checks should carry your Northern California address. You should vote in that precinct. If IRS auditors want to play hardball, they can get copies of utility bills, so yours had better show usage consistent with year-around occupancy.

You see, such a charade can get kind of silly--not to mention expensive.

And to what end? If you were in the highest state and federal tax brackets and did not invoke the $125,000 exclusion, you would pay about $43,750 more in taxes than if you took advantage of the exclusion. But in order to save this $43,750, you would have to keep you home vacant for a minimum of three years. Over 36 months, this works out to $1,215 per month in foregone rent. If you charge your tenant any more than this, you would be losing money. And even if you charge less, you would have to figure in the cost of fabricating your year-around existence in Northern California.

Finally, let’s talk about your age. If you elect to go ahead with this charade, you would be nearly 90 years old before you could reap any benefits. But unless you need the money right now, you may be better off leaving the property in your estate. Why? If the house is held as community property with your wife, she would be entitled to a full step-up in its value upon your death, virtually wiping out any income tax obligations on the gain altogether.

If you are the sole owner of the home and leave it to your children, the value of the property is also reset as of the date of your death, again eliminating any taxable gain. Although you won’t be able to enjoy the benefits directly, your heirs will have many more reasons to remember you kindly.

Inheritance Taxes Hit Resident Aliens Harder

Q: My wife is a German national with permanent resident alien status here in the United States. Since our marriage we have mingled our assets and purchased a home together. Now I hear that because my wife is not a citizen, she would be hit with a huge inheritance tax bill upon my death. Is this true? Is there anything we can do about it? --B.T.

A: Inheritance tax laws do treat non-Americans differently than U.S. citizens.

Specifically, resident aliens are now denied what is commonly known as the “unlimited marital deduction.” Under this deduction, spouses are generally allowed to pass assets to their surviving spouse free from estate or gift taxes.

However, since November, 1988, surviving spouses who are resident aliens have not been allowed to claim this deduction.

Why? The law was changed after Congress became concerned that it was too easy for non-citizen surviving spouses to inherit a huge estate tax-free and then return to their homelands without paying the government its fair share. Remember, marital assets held as community property are treated to a full step-up in value to that at the deceased’s date of death. This allows any untaxed appreciation of those assets to escape the reach of the government.

Congress obviously believed that this was all right in the case of citizens who were likely to stay in the country and spread the wealth domestically. However, foreigners were considered another matter; they could take the money and run back home, and Congress didn’t want that to happen.

However, there are ways around this. Couples, where one of the spouses is a U.S. citizen, can establish what is known as a “qualifying domestic trust” for their marital assets. Property in these trusts is not subject to inheritance so long as the principal is left untouched by the surviving resident alien spouse. You should consult a qualified tax or estate planning attorney to set up such a trust.

Another solution is the $10,000 gift any individual is entitled to make every year to anyone else. You can begin now to give your wife a share of your marital assets in $10,000 increments. However, these gifts cannot be made retroactively. The value of this strategy would depend on the amount of your assets and your age.

Yet another and perhaps most obvious solution would be for your wife to become an American citizen. This, however, could take time. Again, its value depends on your age.