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  • Writer's pictureSteve Coker, CFP

Downsizing your house in retirement

Downsizing your house in retirement can make a lot of sense, especially when you are looking for ways to make your retirement dollars go further. After all, the kids are likely out of the house, and having a large home with a big mortgage and expensive upkeep may not be the best use of your money. Of course, for those of us in California, it can also be tempting to move to a lower cost state in retirement, and many of my clients are doing just that. Before making the decision to downsize your home, however, it is important to make sure you’ll get the savings you expect. Here are a few important considerations before making the move.

First, it is important to calculate the income tax that you may owe if you sell your home. Many are surprised to hear that the gain from the sale of your primary residence could subject to tax, so don’t get caught unaware. Current law (IRC Sec. 121) provides for a $250,000 per person ($500,000 per married couple) exclusion on gain from sale. The ‘gain’ is the proceeds from selling your home less the cost basis in your home (usually what you paid for the house plus any improvements you made).

How to know if you are eligible for the $250,000 per person exclusion:

If you have lived in your home for many years, you may have a significant gain, so make sure you are eligible to receive the $250,000 per person exclusion. The basics are as follows:

1. You must have lived in the house for at least two years.

2. You must have lived in the house as your principal residence for two of the last five years, ending on the date of sale.

Be very careful with rental properties because the rules for rental properties have changed. You can no longer simply move back into your rental property for two years and claim a full $250,000 per person exclusion. Effective January 1, 2009 you must now pro-rate the exclusion based on the amount of time you lived in the property divided by the length of ownership.

On the other hand, there are several exceptions that may allow you to claim the exception even if you don’t meet the basic requirements. These exceptions include “unforeseen circumstance” such as divorce or natural disaster. If you are unsure if the exclusion applies in your situation, I suggest you consult your tax advisor.

How to calculate your cost basis:

To calculation your gain on the sale of your home your need to know your cost basis. Don’t confuse your cost basis for your mortgage balance, these are completely different things. Your cost basis starts with the purchase price of your home, including settlement fees, closing costs and commissions. Add capital improvements you have made to the home. Improvements do not include repairs. A good rule of thumb is that improvements add to the value of your home, while repairs restore the property to its original condition.

Be careful with home office expenses. Depreciation from a home office will be subject to ‘deprecation recapture” and will result in a tax even if your gain is less than the exclusion. If you have taken a home office deduction, I suggest you consult with your tax advisor.

Secondly, it is important to be aware of property tax considerations. For those of us in California, Proposition 13 sets a 2% maximum increase on the assessed value of a homeowner’s property. As a result, homeowners who have lived in the same property for many years will often have a very low property tax basis compared to the fair market value of their home. However, Proposition 13 allows for the property tax basis to be reset when the property is sold, and the general rule is that the assessed value of the new home will start with the purchase price. These complex rules can have the strange outcome of a retiree moving to a less expensive home with higher property taxes. Thankfully, there are a couple of laws that allow property owners over the age of 55, subject to some restrictions, to transfer their property tax basis to a new home of equal or lesser value. Simply put, these laws allow retirees to move to a new home without resetting their prop 13 tax basis, potentially saving thousands of dollars in property taxes each year.

The exceptions are not automatic however, and there are rules that must be followed. If you would like to learn more about keeping your property tax basis, please see our previous article dedicated to that topic here:

Lastly, it is important to make a wise choice when choosing your new home. There is no right or wrong answer here, but it is important to consider all the costs. For example, moving into a condo may result in a much lower mortgage, but what will be the homeowner’s association fees, and do they have the potential to rise over time? Similarly, moving out of state may result in a much lower mortgage, but may result in higher property taxes that rise over time as the property’s value increases.

If the goal of downsizing your home in retirement is to release you from the worry, then make sure you are achieving that goal.


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