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This article is particularly poignant from a personal timing perspective because just last week I covered the topic of how advisors can help clients figure out the best place to live in retirement. On an even more personal level, my father recently mentioned to me that he and my mother are thinking are about downsizing.
As advisors know, clients downsizing homes in retirement is practical on a number of levels. Presumably, retired folks don’t have adult children living at home (some do) and two people usually don’t need the space required by a family four or five. Plus, there are (hopefully) financial benefits. In an ideal scenario, the retired client either owns outright the house that’s up for sale or has significant equity in it, meaning that when it’s sold and the move is completed, there are substantial profits that can directed to other purposes. Those include hobbies, travel, fortifying retirement accounts and long-term care costs.
Profits are always nice, but selling a home at a profit is similar to doing the same with stocks, bonds or financial instruments. Translation: there are no free lunches, but there are tax implications and those tax issues underscore why clients that are considering downsizing should include their advisors in the process.
Downsizing Taxes Necessary Evil, But not too Complex
It’s not a stretch to say practically everyone knows that the U.S. system of taxation is complex and unnecessarily so at that. Interestingly, the tax issues pertaining to the profitable sale of a primary residence are rather straight-forward.
“Under current law, if you sell your principal residence for a profit, you may be able to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from your income tax,” notes Hayden Adams of Charles Schwab. “This may not be an issue for most people, but if your home has appreciated considerably, you could face a significant bill.”
There are two important, though easy-to-understand stipulations. In order to claim that tax break, the sale must occur at least two years after purchase and the house in question must have served as the seller’s primary residence for at least two of the prior five years.
“There are exceptions to these rules—for example, moving before owning the home for two years due to a job change or experiencing what the IRS designates an ‘unforeseen circumstance,’ such as a divorce or natural disaster,” add Adams. “In such cases, the IRS will allow you to prorate the exclusion. One thing to note: If you divorce after having lived in the home for just one year, you would be entitled to only 50% of the exclusion.”
Other Downsizing Considerations
Clients and retail investors reading this article should note that what’s outlined is above is the simple part of the taxes involved with selling a primary residence at a profit. There’s more meat on this bone, confirming conversations with accountants and advisors are necessary.
As for advisors, they need to realize that there are other considerations when it comes to downsizing. For some clients, it’s possible that they simply like where they are now and don’t want to move. Others might be planning to use their home as the primary asset to be left to their heirs. For some, selling the house and then renting could be on the table.
“There's no right or wrong answer. A lot will depend on where you live and how long you plan to stay in your next home. In either case, if you make a considerable profit on the sale of your home, talk to your financial advisor about the best way to invest this money in light of your overall financial situation,” concludes Adams.
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