Capital Gains- home sale questions

[mtnman125]

My wife's family is going through some interesting living scenario changes and looking for some tax advice.

House #1 near Chicago is a 2 flat with grandparents living downstairs, parents living upstairs. Parents spend very little time there though.
House #2 in Arizona- bought as a retirement house ~8 years ago and spend majority of time there.

Grandparents will be moving to Arizona soon and house in Chicago will be sold, then some time after parents want to build/buy a larger house and sell current Arizona house.

They are curious how capital gains taxes work in that scenario. Would the Chicago house be considered primary residence and therefore have $500k exemption- but AZ house would be taxed on difference between original purchase price and selling price?  What are the capital gains rates (same as taxable account?)? 

Thanks in advance

[terran]

I think there are a couple of missing pieces people will need to know in order to help you:

1) Who owns each house (that is, who is on the deed)?
2) Does anyone in this scenario pay anyone else rent?
3) Have there been any depreciation deductions taken based on considering either house as a rental at any point?
4) You say the parents have spent very little time at the Chicago house. Has that been true for five years or more? Or have they mostly lived in the Chicago house at any point in the past 5 years? If so, how much time have they mostly been living at the Chicago house during the past 5 years?

[mtnman125]

Thanks Terran-

1) 50/50 Grandparents and Parents
2) No, but parents pay all utilities. (FWIW, because grandparents are seniors there is a freeze on property tax)
3)No
4) I would say on average they spend 1-2mo/yr in Chicago house for the last 5 yrs, the balance in AZ.

[terran]

From what you say it sounds like the Chicago house has been your grandparents primary residence for at least 2 of the last 5 years, but it has not been your parents primary residence for any time in the last five years. It sounds like the Arizona house has been your parents primary residence for at least 2 of the last 5 years, but it has not been your grandparents primary residence for any time in the last five years.

If you're saying your parents and your grandparents each own half of each house, then it would seem your grandparents can exclude up to $500k of the gains on the sale of the Chicago house and your parents can exclude up to $500k of the gains on the sale of the Arizona house.

Given this 50/50 arrangement your parents (Chicago) and your grandparents (Arizona) will have to pay taxes on the gains from the sale of the homes that were not their primary residence and on any gains in excess of $500k on the homes that were their primary residence. Capital gains on the sale of a home that aren't excluded as a primary residence are just like any other capital gains you might have (such as a taxable account).

Unless your parents want to move back to Chicago for two years that's a done deal, so they'll be paying their half of the gains there. Something they could consider is having your grandparents move to Arizona and waiting to sell the Arizona house for at least two years after the sale of the Chicago house. That way your grandparents could exclude the gains on the sale of both houses. Note that they'll need to both be living their as a primary residence for at least two years and it must have been at least two years (to the day) since the Chicago house sold.

Since at least your parents, and possibly your grandparents will probably be paying tax on the capital gains it would be worth looking back through their records and see what they can cobble together to increase the cost basis of the homes. Obviously the original purchase price counts, so do capital improvements to the house, but not repairs. The broad strokes difference is an improvement is something that adds value to the house while a repair just fixes something that wore out. Obviously there is lots of grey area there, so take a look at the link below.

For the official source on all of this (including a good list of "Examples of Improvements That Increase Basis" on page 9) see Publication 523.

[mtnman125]

Wow, thanks for the thorough response.

The grandparents have no financial involvement in Arizona house, so looks like they wont owe anything for Chicago house, and parents will just owe capital gains on their half of the balance between sell price and purchase price (interesting there is no inflation adjustment for that- 25 years is a long time to compare purchase/sell price).

Since parents only income is dad's SS and pension, they are probably in pretty low tax bracket anyway- so worst case will be 15% then I think.  If pension+SS is under $75k, that should mean capital gains is 0%, or do the capital gains dollars push them into a higher tax bracket?

[terran]

Just remember that the capital gains count as income too, so even if they're otherwise fairly low income, if the gain is large they could end up in a pretty high capital gains bracket (not that capital gains rates go all that high). Capital gains stack on top of regular income as you go up through the brackets.