Death and Taxes - The Blog

"The Break-Up" and Unmarried Clients

This past weekend I saw The Break-Up, the Jennifer Aniston-Vince Vaughn comedy about an unmarried couple that decides to part ways.  One of their problems involves the condo that they bought together -- each of them feels entitled to it.  (At one point Vince Vaughn says something like the following to their realtor: "I've thought about it, and the only fair thing would be for her to move out and pay me some kind of penalty.")

Dealing with unmarried clients and their property is difficult for attorneys.  Unmarried couples have either chosen to have a less formal relationship than married couples, or (in the case of same-sex couples) have been prevented from having a more formal relationship.  As a result, many of them don't think about taking other steps (like executing Wills and trusts, or creating a co-tenancy agreement for jointly-owned real estate) that can make the relationship more formal.  Helen W. Gunnarsson talks about this issue in June's edition of the Illinois Bar Journal, in an article called "What to Do When There's No 'I Do.'" (I can't tell, but access to this article may be restricted to members of ISBA (the Illinois State Bar Association.)

Sherwin Abrams on Real Estate Taxes

Property taxes in Illinois are paid in arrears -- '05 taxes get paid in '06, '06 taxes get paid in '07, and so on.  To make matters worse, in Cook County you have to wait for the second installment tax bill to come out in order to figure the whole year's taxes, since the first installment bill is always 50% of the previous year's taxes. 

This weird way of handling real estate taxes makes it difficult on sellers and buyers of real estate (and their attorneys).  Sellers of real estate typically give buyers a prorated credit at closing for real estate taxes, because the buyer will be receiving tax bills for time periods when he or she didn't own the home.  Determining the amount of this credit involves a LOT of guesswork and negotiation.  Do we assume that taxes will increase by 5%? By 10%?  By more (or by less)?

I belong to a transactional law e-mail group made up of members of the Illinois State Bar Association (ISBA).  Today, a Chicago attorney named Sherwin Abrams presented a thoughtful and fairly revolutionary post about these tax prorations.  Mr. Abrams' post also makes some interesting comments about the state of residential real estate transactions.  Mr. Abrams has graciously agreed to allow me to present his post in full -- here it is:

Why do we make such a big deal about prorating real estate taxes?  Would not life be simpler if we changed our practice so that the seller paid all taxes that were due and payable prior to closing and the buyer paid all taxes that become due and payable after closing?  In other words, let’s abolish prorations.

Not fair, you say.  It is the 2005 taxes that are paid in 2006, and the seller should pay the taxes that accrued while he/she owned the property.  But what’s in a name?   Does it matter  that we say that it is the 2005 tax that is being paid in 2006?  What if we call the tax that is paid in 2006 the 2004 tax or the 2007 tax?  The fact is that tax must be paid in 2006, and we do not expect there ever to be a year when there is no real estate tax.

Even if you hold to the fiction that we are always paying last year’s taxes so that it would be unfair to the buyer not to prorate, everything will even out when this year’s buyer becomes next year’s seller.  Not having received a credit when he/she bought, our buyer would not have to give a credit when he/she sells.

Even if you are not willing to eliminate prorations altogether, it does not make much sense to argue over the amount of the proration.  OK, you might agree, in most years taxes are not going to change all that much so that it costs more to make an issue of whether the proration should be at 105% or 110% than it is worth.  But what about years when the tax might increase by as much as 50%?  Yes, indeed, the buyer should be wary of buying when taxes might jump, but not just for the year of purchase.  The buyer should be concerned with whether he/she will be able to pay the taxes in all the years to come when that 50% increase will remain in effect.

No, I do not expect the bar to change its practice so that we can rid ourselves of this unnecessary complication to what used to be called a simple house closing, no more than I expect another of my proposals to be widely adopted: namely, that the buyer should choose and pay for his/her own title insurance just as the buyer chooses and pays for his/her own home inspector.

Let me warn you, though, that the residential real estate practice is broken.  Negotiations are too contentious; contracts are too complicated; mortgage documentation is too voluminous; closings take too long and are too stressful.  The entire process of buying a home is much too expensive.  If the lawyers and the brokers and the lenders and the title companies do not try to do something to simplify the process, the People, acting through their duly elected representatives, will.  And that will make matters even worse.

Sherwin D. Abrams (e-mail)
Abrams & Chapman
321 S. Plymouth Ct.
Suite 1200
Chicago, IL 60604-3996
312-360-9207
312-360-9212 (fax)

Follow-up #1: Gifting a Home

Last week I shared a true story about a tax-related cost of gifting your residence.  The author of one of my favorite law blogs, Deirdre R. Wheatley-Liss, also posted on this topic recently, and fleshed out why gifting can be such a bad idea.  Her post is here.

Another Reason Not To Gift Residence

There are a lot of reasons NOT to give away your residence during your lifetime.  Many of those reasons have to do with relationship issues -- if you give your house to your son and then have a fight with him, will he kick you out? -- but tax concerns also play a part.  Here's a situation involving an acquaintance of mine -- the names and some details have been changed, but the main facts are accurate:

Joe Smith buys a house on the north side of Chicago in 1950 for $45,000.  In 2000, Mr. Smith makes a gift of the house to his only child, Marge, who lives there with (and cares for) him.  In 2005, Mr. Smith dies -- the house is appraised at $1.3 million. 

If Mr. Smith had owned the house at his death, Marge would have inherited it with a ("stepped-up") basis equal to the house's value at his death.  Marge then could have sold the house and paid no capital gains.  However, when Mr. Smith gifted the house to Marge, Marge assumed Mr. Smith's basis in the house -- let's say that's $45,000 (although improvements to the house may have increased that number a bit).  If Marge now wants to sell the house, she'll have a gain of around $1.2 million.  Some ($250,000) of that gain is excluded from taxation, but Marge will still have to pay tax on almost $1 million of gain.

One final point: gifting the house might have made more sense (at least from a tax perspective) if Mr. Smith had a bigger estate, since the estate tax rates are higher than the capital gains rates.  Excluding $1.3 million from your estate may be a good idea.  However, Mr. Smith had very few assets other than the house -- about $100,000 -- so his estate wasn't subject to estate tax at all.

Assessments and Privacy

One issue I've been following since I began this blog involves privacy and public records on the internet.  This article details a Pittsburgh-area politician's attempt to prevent public searches on the Alleghany County Assessor's website.  The goal of the politician (Councilman William Robinson) is to prevent criminals from being able to easily find personal information for individuals owning real estate in Alleghany County.  (The public could still obtain such information by filing an official request -- it just wouldn't be available immediately via the internet.)

Councilman Robinson's goal may be laudable, but it seems to provide an overly-broad solution to a fairly narrow problem.  As mentioned in the article, the Assessor's website provides lots of different information to its visitors.  Some of that information is very important and raises very few privacy concerns (for instance, the information on assessments helps in the assessment appeals process).  Other information strikes me as less valuable and more intrusive (allowing searches for property by the owner's name).

A couple of other points:

1. It's also worth noting that the website no longer includes the names of federal, state or local judges.  The tricky question (raised here by the president of the Pittsburgh chapter of the Fraternal Order of Police) is, why stop with judges?  And, if we don't stop at judges, where do we stop?

2. It's fairly easy to take title to property in a way that provides some privacy protection (by doing so via a land trust or a corporation, for instance).  However, is it really fair to make privacy protection available only to those who are wealthy and/or sophisticated enough to use these vehicles?

"Unforeseen Circumstances" and the Capital Gains Exclusion

I wrote a little about the $250,000 capital gains exclusion on the sale of a home here.  The basic rule is that you can exclude from taxation up to $250,000 in gains on the sale of real estate, so long as you have owned and occupied the real estate as your principal residence for at least 2 of the previous 5 years.  But even if you don't meet the 2 year "owned and occupied" requirement, you may still be eligible for a partial exclusion from capital gains if you are forced to move due to "unforeseen circumstances," according to this interesting article by Sandra Block of USA Today. 

Resource Page: Local Transfer Tax Information

An increasing number of cities and villages in the Chicagoland area have their own transfer taxes that apply to the sale of real estate, and their own procedures for paying these taxes.  This page is meant to be a resource for attorneys and other individuals needing to obtain transfer tax procedural information (including forms).  My goal is to list links to transfer tax information by municipality, in order to streamline the process of obtaining this information.  To that end, I ask that readers e-mail me if they come across this information for a city or village not yet listed below -- I'll then update this page with such information.

Aurora: procedures, transfer tax form (pdf)

Elmhurst: procedures (pdf), application for refund form (pdf), certificate of exemption form (pdf), transfer tax form (pdf)   

Oak Park: procedures, transfer tax form (pdf)

Gifts of Real Property and the $250,000 Capital Gains Exclusion

Robert J. Bruss makes some interesting points in his recent "Real Estate Mailbag" column, found in the Washington Post (and here).   Some background: §121 of the Internal Revenue Code excludes real estate from capital gains tax under certain circumstances.  Basically, you can exclude from taxation up to $250,000 in gains on the sale of real estate, so long as you have owned and occupied the real estate as your principal residence for at least 2 of the previous 5 years.  With that in mind, Mr. Bruss considers a case where a woman transferred her home to her child as a gift (the child now wishes to sell the home).  Mr. Bruss concludes that the transfer was a big mistake, at least for tax purposes -- the child doesn't meet the requirements under §121, and will owe taxes on his or her gain (the difference between the sales price for the home and the child's basis in the home).

A similar question involves a parent who places his or her child on the title to the parent's home as a joint tenant.  I've previously talked about how such an arrangement is a bad one from an estate planning and property perspective.  It also seems to me that, under this scenario, the child would not be eligible for the $250,000 exclusion from capital gains for his or her one-half interest (unless, of course, the child owned and lived in the home for the time period set forth in §121).  The parent, of course, would still have his or her $250,000 exclusion, to apply to his or her one-half interest.

Tax Prorations and Reproration Agreements

Tax prorations are one of the most difficult things for new homebuyers to understand. Why are they needed? What do they do?

The whole concept of tax prorations exists because Illinois real estate taxes are paid in arrears – in 2005, homeowners pay real estate taxes for the 2004 calendar year; in 2006, homeowners will pay real estate taxes for the 2005 calendar year; and so on. That means, after a home sale is completed, the new owners will receive real estate tax bills for the home that are attributable to a time period when the new owners didn’t own the home.

Tax prorations attempt to solve this problem via rough justice. We take the taxes for the last ascertainable full tax year, and make assumptions about the extent to which these taxes will increase over the next year (or two).  For instance, if you buy a home in Cook County on June 30, 2005, then 2003 will be the last fully ascertainable tax year.  (In Cook County, we won't find out the 2004 taxes until the 2004 second installment tax bill comes out in the fall -- more on that tomorrow.)  If the tax proration percentage in the contract is 110%, then we're assuming that taxes will increase by 10% from 2003 to 2004 and by 10% from 2003 to 2005.  An example might help:

Let's assume that (a) the 2003 real estate taxes on a (Cook County) home were $5,000.00; (b) the first installment 2004 real estate tax bill (equal to one-half of the 2003 taxes, or $2,500.00) has been paid; and (c) the home is sold on June 30, 2005.

If the tax proration percentage is 110%, then the seller will need to pay the buyer the following credit amounts at closing:

2004 real estate tax credit: ($5,000 x 1.1) - 2,500, or $3,000.00

2005 real estate tax credit: ($5,000 x 1.1) x (181/365), or $2,727.40

That's a total real estate tax credit of $5,727.40. (Note that 181 is the number of days from 1/1/05 to 6/30/05, the day of closing.)

Of course, sometimes the buyer and the seller may not want rough justice.  While we can assume a 10% tax increase, in doing so, it's likely that one of the parties will wind up paying too much.  If the taxes increase by more than 10%, then the buyer has to pay more than his or her fair share; if the taxes increase by less than 10%, it's the seller who suffers. 

There's a solution to this problem, in the form of what's known as a reproration agreement.  When taxes are reprorated, the seller may still give the buyer a credit at closing, but the credit amount will be adjusted when the actual tax bills are made public.  To continue with the above example: what if the 2004 second installment tax bill comes out, and the taxes are actually $2,800.00?  In that case, the buyer will pay the seller $200.  Or, if the second installment tax bill is $3,300, then the seller will pay the buyer an additional $300.

Reproration agreements aren't used very often for two reasons:

1. Usually parties don't want to revisit the real estate tax issue (or any other issue) after closing.

2. The amounts in question are usually fairly small (perhaps too small for the parties to argue about).  For instance, to return to the above example, the difference in credit amount between a 105% proration percentage and a 110% proration percentage is less than $400. 

Down with the Home Mortgage Interest Deduction?

I meant to post this article last Friday (Tax Day), but got a bit carried away with estate tax repeal issues.  The article (by Daniel Gross of Slate) takes an interesting look at the income tax deduction for home mortgage interest.

I think it's an important article both for the specific issues it raises about the deduction, and for its more general points about the messiness of the tax code (and our reactions to it).  From time to time, I hear people talk about how we need to simplify the Internal Revenue Code and make it more fair, when those two goals (simplicity and fairness) often seem mutually exclusive.  As the article indicates, even when we pinpoint a problem we can solve, the problem may persist simply because of politics (and self-interest).   

Mr. Gross cleverly addresses this with his opening paragraph:

"There's a cancer at the heart of our increasingly complex tax code. A special deduction that disproportionately benefits the wealthy and distorts economic activity has grown rapidly in size and could cost taxpayers nearly $100 billion annually by 2009. Eliminating it would allow us to reduce levies on income and rationalize the system. According to Martin Sullivan, a contributing editor of Tax Notes, its existence 'means the economy has less business capital, lower productivity, lower real wages, and a lower standard of living.'"

Many (most?) Americans would support elimination of the deduction described above.  But if you instead took a poll asking "Do you support the elimination of your income tax deduction for home mortgage interest," most people would answer "no."