Real Estate, 2003

eal estate is back! Not that it ever left. Real estate doesn't go out of style because there is a finite amount of land and people need housing. Bricks and mortar are generally more stable than the stock market, which reacts emotionally to news with wild swings up and down-sometimes on the same day. Real estate is also tangible; it doesn't just exist on paper and its value cannot simply be erased. And the family home is often the largest asset of an estate and provides a focal point for all planning.¹

Yet real estate values rise and fall in a restless marketplace. Moreover, the tax treatment of capital gains on real estate investments has undergone a transformation. The role of the family home in an estate plan also must be evaluated in the context of the impending limit on the stepped-up basis for capital assets held at death and, of course, the elimination of the estate tax. Let's review where all of these changes leave us with regard to real estate in general and the family home in particular.

An Abbreviated Retrospective

In the early 1980s, real estate ruled. But problems materialized by the end of that decade. There was deficit spending and the savings and loan crisis. The economy soured and real estate values collapsed. The Resolution Trust Company sold off real estate assets in the S&L clean-up effort.

Japanese businesses, then standing astride the world of business and having bragging rights to an economy that we could only envy, swooped in to purchase bargains such as Rockefeller Center. Ironically, Japan's own inflated real estate values were propping up the Japanese economy and stock market. This bubble economy eventually burst, causing a number of Japanese entities to sell off their American real estate prizes-even at a loss.

By the early 1990s, the American economy began to turn the corner. A prolonged period of economic growth, coupled with low inflation and low interest rates, provided a nurturing environment for real estate assets. By the end of the '90s, real estate was approaching and surpassing its previous highs.

But this was a time when investments were focused on the Internet. Periodic "tech wrecks" did not dissuade investors from pouring money into any business with a "dot.com" in its name…regardless of how many years it would take such companies to turn a profit. It was hard for investors to resist annual stock market returns exceeding 20%. It was an endless expansion…until it ended. When the stock market technology bubble burst, investment money sought out real estate as a safer haven.

The Current Context

Our post-millennium economic blues were supposed to have passed by now, but corporate scandals, September 11, Afghanistan and Iraq have postponed economic recovery. This in turn has kept interest rates exceedingly low. As a result, there has been sustained interest in real estate. Suddenly, estates are house-rich again. In a seller's market, homeowners have a new spring in their step. Real estate investment trusts (REITs) and securitized land investments are popping up in portfolios. And Congress found it fashionable to allow 401(k) plans to contain real estate investments.

We have been to the summit of real estate before and must be wary; when you are at the top, it's downhill in every direction. If one didn't mind the inconvenience, one could sell one's home at the peak of the market, keep the cash proceeds parked on the sidelines by renting for a few years and then reinvesting in a home when the market inevitably shifts lower.

At one time, just a few short years ago, such a maneuver ran into several capital gains consequences and might not have been advisable for estate-planning purposes. But today, the entire tax context has changed. Compare the change in taxation philosophy in the following areas:

INCOME TAX: The income tax only became a permanent fixture in 1913. The top rate was initially 7% but revenue needs and a fixation on the progressive rate structure led to a rate as high as 94% in 1944. From 1965 through 1981, the top income tax rate remained at 70%. In 1981, the Economic Recovery Tax Act (ERTA) began reducing the top rate to 50% over a three-year period. Top rates have since been reduced several times, holding at 39.6% and 38.6% in recent years and now arriving at 35%, thanks to the Jobs and Growth Tax Relief Reconciliation Act of 2003.

CAPITAL GAINS: A top rate of 35% on long-term capital gains only seems like a tax break when top rates are in the stratosphere of 70%. When top income tax rates remained at 50%, a 60% exclusion established 20% as the maximum capital gains rate. In the 1990s, the top rate was increased to 28%. But recent tax reforms returned the top rate to 20% and then 18% for certain ultra-long-term capital gains. Under the Jobs and Growth Act, the top rate is 15% but will expire after 2008. The 18% rate associated with a five-year holding period was repealed.²

HOME EXCLUSION: In the past, a one-time exclusion of $62,500 ($125,000 for married couples filing joint tax returns) applied to capital gains on the sale of a primary residence by someone age 55 or older. The capital gains strategy for homes therefore involved rolling over capital gains from one sale to the next until reaching age 55. Profits on the sale of a residence had to be used to purchase another primary residence within two years before or after the sale.

Under the Taxpayer Relief Act of 1997, the entire approach changed. Instead of a one-time exclusion, there is a renewable exclusion that can be used every two years. Up to $250,000 of gains ($500,000 for married couples filing jointly) is free of gains.

STEPPED-UP BASIS: The old approach allowed assets owned at death to be transferred to beneficiaries with a basis that is stepped up to the value of the assets on the date of death. It has been an obvious loophole that was philosophically at odds with the tax code. But after a spectacular failed attempt at imposing a carryover basis in 1976, Congress left well enough alone for 25 years. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the tax basis in capital assets will be "carried over" after a person's death for the estates of decedents dying after 2009. There will still be a limited stepped-up basis of $1.3 million for nonspousal transfers and $3 million for spousal transfers.

ESTATE TAX: At one time, federal estate tax brackets were broken into 25 separate brackets that peaked at 77%. In recent years, the top rate remained at 55% with an additional surtax of 5% on certain estates and a unified exemption protecting $600,000 of an estate. The Taxpayer Relief Act of 1997 began phasing in a larger unified credit with an exemption equivalent of $1 million by 2006. Under EGTRRA '01, the estate tax is repealed after 2009 (subject to a sunset provision the following year). In addition, the top rate is being lowered and the exemption amount is gradually increased. For 2003, there are 15 estate tax brackets that peak at 49% and $1 million of an estate is exempt from tax. For 2004, the top rate will be 48% and the exemption will rise to $1.5 million.

	PAST	PRESENT & FUTURE
INCOME TAX	70% (1965-1981); recently 38.6%	35%
CAPITAL GAINS	20% for many years and again recently	15% (possibly increasing after 2008 sunset)
HOME EXCLUSION	$62,500 ($125,000 married couples) one-time exclusion for age 55	$250,000 ($500,000 married couples) exclusion available every two years
STEPPED-UP BASIS	Full stepped-up basis for capital assets held at death	Step-up limited to $1.3 million nonspousal, $3 million spousal
ESTATE TAX	55% top rate with 5% surtax and exemption of $600,000	For 2003, 49% top rate with $1 million exemption; estate tax phases out, repealed after 2009 (subject to sunset)

Keeping It Real

The collection of former tax rules dictated strategies that must be now reevaluated in the context of each estate. Having lower rates on capital gains and less chance for a stepped-up basis in the future are two reasons that encourage current transfers of appreciated assets over long-term retention of such assets.

Instead of rolling over the capital gains on the sale of a home until age 55, homeowners now can sell a primary home every two years and take advantage of much a higher exclusion. With the latest reduction of the top capital gains tax rate, the sale of luxury homes which have appreciated more than $500,000 is somewhat more attractive as well.

Clearly, everything is relative. For example, Mr. and Mrs. Johnson bought a home eight years ago for $500,000. The home is now worth $1 million. The Johnsons can sell their home and use their $500,000 exclusion (since they file joint tax returns) to avoid any tax on the gain.

Mr. and Mrs. Jackson bought a home 10 years ago for $3 million. The house is now worth $6 million. If they sell the house, they can exclude $500,000 of gains and will face a capital gains tax of 15% (possibly 20% if the sale takes place after 2009) on the remaining $2.5 million of capital gains. If they retain their home until their death, they can take advantage of the limited stepped-up basis that is available. Note, however, that the Jacksons may need to apply their stepped-up basis amounts to other appreciated assets.

Taking advantage of a limited stepped-up basis requires a closer look at which assets will be transferred and to whom. It is possible that an appreciated asset may be transferred after death from one family member to another and never sold. Other critical factors include life expectancy, future appreciation of assets, and available records to demonstrate an asset's basis.

Consider also the juxtaposition of capital gains and income tax. It was recently a gap between 28% ceiling on capital gains and 39.6% for the top rate. This 11.6% differential grew to be an 18.6% differential under the basic rates of 20% for long-term (one-year) gains and 38.6% as the top income tax rate. With a top capital gains rate of 15% and income tax rates peaking at 35%, the differential has reached 20%. The entire composition of an estate may need to be adjusted to recognize where the highest tax burdens now lie.

Technical References

¹The family home was easily the largest asset in most estates until recently. Over the past generation, qualified retirement accounts, most notably 401(k) and IRA rollover accounts, rose in significance. In many estates, the surge of the stock market pushed these retirement portfolios into position as the number-one asset. With the fall of stock values and the rise of real estate, family homes may have regained their primary asset status.

²Several past issues of this newsletter provide related information. See, Moshman, "The New Carryover Basis", The Estate Analyst (March, 2002); Moshman, "21st Century Gifts", The Estate Analyst (February, 2000); Moshman, "Real Estate Ramifications", The Estate Analyst (November, 1996).

© R. Moshman, 2003