Can My State of Residence Affect My Federal Income Tax Bill?

state property laws

Our federal income tax code is uniform for every state in the union, so one might conclude that the answer to this question would be “No”. However, the fact that property law is not uniform across the nation can actually create a circumstance where this can become a reality.

Take for instance the IRS exclusion for the capital gain generated by the sale of a principal residence. This exclusion is one of the largest tax breaks available to any of us and can be applied to the capital gain generated by the sale of a principal residence that has been owned and lived in during at least 24 months of the previous five years. Single filers are permitted to exclude $250,000 of such realized capital gains and a married couple executing such a qualifying home sale can exclude $500,000. When a jointly owned house is sold by a surviving spouse after the death of a co-owner spouse, federal capital gains taxes may be very different depending on the state where that home is located.

Let’s consider Doug and Deidre who have owned and lived in a house in Barrington, Illinois for many years. They paid $100,000 for the property in 1969 and it is now valued at $1,200,000.  Doug passes away and his cost basis in the house now receives a “1/2 step-up” to $600,000 ($50,000 original basis + ½ of the difference between $100,000 and $1,200,000). Deidre’s basis remains at $50,000.  This result is due to the fact that Illinois is a “separate property” state where joint owners are usually deemed to have each provided 50% of the original basis. If Deidre has not remarried and sells the house in 18 months for $1,250,000, her cost basis will be the sum of her original $50,000 plus Doug’s stepped-up basis of $600,000, or $650,000. Since the gross proceeds of the sale are $1,250,000 her capital gain is $600,000 (the difference between the sale price and her cost basis). The IRS code allows her to exclude $500,000 of this capital gain because she sold the house prior to the end of the two year period starting on the date of her husband’s death. Had she waited more than 24 months to consummate the sale (and had not remarried), she would only have been allowed to exclude a capital gain of $250,000 as a single taxpayer. Either way, Desiree gets hit with the taxes due on a capital gain of either $100,000 or $350,000 depending on how soon she makes the sale. Most U.S. states are separate property states, so this example would apply very frequently.

However, now consider Dave and Desiree who have exactly the same circumstances with the only exception being that they purchased a home in Newport Beach, California. California* is a community property state and the tax treatment is very different from Illinois and the other separate property jurisdictions. The cost basis at Dave’s death becomes the full market value of $1,200,000 and if Desiree sells the house within 24 months for any amount less than $1,700,000, the $500,000 exclusion will wipe out any capital gains tax due.

 This disparity in tax treatment can also apply to other jointly owned capital assets such as financial securities in a brokerage account. It just doesn’t seem fair, does it?!!??      

*Other community property states are Texas, New Mexico, Arizona, Washington, Idaho, Nevada and Louisiana. Wisconsin has a concept called marital property which is treated similarly to community property. 

If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.  You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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