Thursday, May 25, 2006

Taxes on a "Special" Home Sale



I have a couple of questions for all you readers. Not that this affects me personally, but I haven't been able to track down the answer, and it does intrigue the heck out of me.

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?

— Posted by Michael @ 8:22 AM








4 Comments:
 

Personally, after reading that article I think there were a lot of things they could have done differently. They've been foolish.

 

Hi Michael! It's funny you should raise that question, because when I read the article, I thought the writers dropped the ball on the tax question and what they'd net after the sale. I don't have the IRS code reference, but when I was in my financial planning classes I proposed this exact scenario to my professor. (Yeah, I was planning for when I'd win the HGTV Dream Home!) His explanation, and thus my understanding, is that the "winner" of the home owes the tax on the fair market value of the winnings. (Yeah, we already knew that part...) If they later sell the home, the basis of the house is not zero, but is what the "winning fair market value" on which they paid their taxes. Of course, in their case, they would have to back out the $250,000 cash and the car, etc. A provision would undoubtedly have to be made for the furniture/home's contents as that would be personal property and is not considered real estate. Thus the home sale w/contents would have two components: real estate sale and personal property sale. Even if they don't sell the furniture, they have to "peel back" the layers of values of the other winnings: cash, car, furniture, etc. to get to the core real estate home value. You're correct that the home sale exclusion requires "ownership and use" for 2 out of 5 years (doesn't have to be continuous--you could "winter" somewhere 6 months during a 4-year period and meet the requirement.) There are exceptions that allow a prorated exclusion for residency less than 2 years. These exceptions are: a change in place of employment or health or unforeseen circumstances. There's the rub: the IRS defines "unforeseen circumstances" as 'the sale of your main home is because of an unforeseen circumstance if your primary reason for the sale is the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home. You are not considered to have an unforeseen circumstance if the primary reason you sold your home was that you preferred to get a different home or your finances improved.' Or perhaps in this case, finances deteriorated. IRS Publication 523 Selling Your Home would be an excellent reference for them. Go to http://www.irs.gov/pub/irs-pdf/p523.pdf A good tax accountant is what these folks will need (in addition to a lawyer, a real-estate agent, and a person to teach them how to manage their money--dump the scuba expenses, etc.) In their case, I doubt the home's sale price would be high enough to even worry about obtaining a partial home sale exclusion, but it is an interesting situation! Did this help?

Anonymous StaceyM
, at 9:59 AM, May 27, 2006  
 

I just found this site and comments on the "Money" magazine article about the "Man of LaTyler" and his "Impossible Dream" of keeping the HGTV Dream House he won.

I thought you would be interested in the most recent developements, ie., the tax hurdle.

Seems he acquired a 1M loan (I'm assuming a home-equity type)and in true "Trump" style, threw a huge party at the house, complete with hiring a band from Chicago, for all to celebrate. There's a picture of him standing on the balcony of the house holding the oversized check posted on the HGTV Dream House Message Boards. Then he galloped to the I*R*S office (in a rented limo) and paid the taxes plus the accured penalities and interest. There's an article in the Dallas Morning News about "Don Cruquoite" slaying that windmill. The payments are about $8000 a month and he plans on making these payments with the $300K left over from the loan--with it being completely paid off, we're assuming, when he sells the house.

The "Money" magazine article underscored what I've been thinking all along concerning this idealistic quest to keep this house:

This family had a great gift laid upon their table--and they squandered it, in Don Curz's own words, "to be able to live the life of the rich and famous, if only for a year."

I wonder if they will still have "no regrets" when those happy memories are oblitered by 1M+ debt(I'm including the mortage on the house in Illinois), dimishing resources (that $36K leftover from the cash prize is not going to last long with monthly expenses in excess of $2900), and no steady income stream (neither one of this couple is employed).

There is such a thing as "An Impossible Dream"--this family is living proof of it. Their "Reality Check" should have occurred last June when the Tyler City Council denied their request for an exemption to local zoning laws, which would have allowed them to rent out portions of the house and develope a steady cash flow. The Dallas Morning News covered this with a front page story, photos and sidebar. At that point, "Don Cruquoite" should have seen the writing on the wall and headed straight for a real estate agent upon leaving the Council Chambers. But, the quest continued . . .

Their only hope now is to lower their asking price to one more realistic and compatable with other similiar homes in the area, dump the FSBO route, list with an established, experienced real estate pro and accept the first firm offer that comes along. This will turn their quest into the "Possible Dream."

Anonymous Anonymous
, at 10:09 AM, June 03, 2006  
 

Hello,

Great post. Thanks.

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