Those of you who subscribe to Money magazine are probably familiar with the article from the June 2006 issue which prompts all this. It's entitled "The House That Swallowed Don and Shelly Cruz." If you enjoy watching financial slapstick play itself out, this is right up your alley.
In a nutshell, the Cruzes won a recent HGTV "Dream House" sweepstakes. They were presented with a ginormous lakefront McMansion and guest house (tax-assessed value: $1.8 million), as well as a new SUV and $250,000 cash. And probably some other goodies that just happened to fall beneath the radar of the article's writer.
What the Cruzes weren't blessed with was the ability to plan their way out of this mess.
"What mess?" you non-Money-subscribers might ask. "They just won a huge pile of stuff? How's that a mess?"
Easy. It's the mess that happens when you don't think about the taxes on such contest winnings — which in this case added up to a 2005 IRS tax bill of $672,000. The mess that happens when you had NO idea that JUST THE UPKEEP (utilities, landscaping, etc.) on your new Dream Home would run you $2,900 per month. The mess that happens when your homeowners insurance is $7k per year. The mess that happens when you have all this, and more, and your household income is only $40k per year. And the mess that happens when you've pretty much blown all but $36k of the original $250k cash that HGTV handed you ... on things like dog runs ($6k), scuba lessons ($2k), Christmas presents ($5k), and repairs to the family boat ($11k). And given the situation, I'd say their $40k donation to charity wasn't real bright, either.
(And no, they can't turn the place into a bed 'n' breakfast, or rent out space, because the land the homes are built on isn't theirs. That acre of green grass and tall trees is actually on a 30-year lease, with an option to renew. The local Texas township won't allow such the Cruzes such "business" transgressions on the property.)
Anyhow, here's my question: Suppose the Cruzes do manage to sell this house, which in my opinion is what they've should've done to start with (as well as consult with a CFP on how not to screw up a once-in-nobody's-lifetime windfall).
1) For tax purposes, what's their cost basis in this place? The tax-assessed value, plus any improvements?
2) Supposing they can find a buyer (it hasn't happened yet) for the McMansion, can they utilize the homeowners' tax break which allows them to realize profits of up to $500k tax-free? The financial planners interviewed in the magazine article seem to suggest that this is the case. However, my impression was that the home had to be lived in for two years before this tax break kicks in to its fullest extent. (The Cruzes have only been in their Dream Home for a year or so.)
If I read it right, the financial planners and article writers have the Cruzes pegged for only their current $672k tax burden, and no more, no matter what happens:
Don Cruz believes his family can live comfortably off the sale of the Tyler house, even if they get only $1.75 million. After paying the back taxes, they'd have $1 million left. ...The worst-case scenario is that the Dream Home sells for only $1 million, netting around $250k after taxes.
Anybody have ideas or answers on this "dreamy" scenario?