Personal Finance - Arla Wallace
Arla Wallace is an accounting professional with over 20 years experience. She spent several years working for both publicly-traded and private entities before founding her own business. Today she partners with small business owners so they can focus on operations while leaving the responsibility of staying on top of accounting tasks to her. She is a Certified Public Accountant (CPA) and a Certified ProAdvisor for Quickbooks Online.

Tax Ramifications of Downsizing Your Home in Retirement

Tax Ramifications of Downsizing Your Home in Retirement

What will retirement look like in your golden years? Finding purpose in how you will spend your time will help bring fulfillment in this life stage. The same can be true for downsizing a home in retirement—assigning a financial purpose to your decisions will help bring meaning to an otherwise complex task.

Downsizing your home can be financially practical for several reasons. Larger homes require more of your time and money to maintain. Because property taxes are assessed on the value of your home, a smaller home can lower the amount you owe annually. Smaller spaces with fewer rooms or energy efficient appliances can lower utility costs. And, buying a smaller home with a lower monthly mortgage can allow you to put more money into savings.

Capital Gains Tax

If a gain results from selling your main home, the IRS allows you to exclude $250,000 of the gain from income, or in the case of a joint return, $500,000 of that gain can be excluded from income. To qualify for the exclusion, you must meet both the ownership test and the use test. During the five-year period prior to the sale, you must have owned and used your home as your principal residence for a period of two of the five years ending on the date of the sale. If you have excluded gain from the sale of another home during the two-year period prior to the date of sale, you will not qualify for this exclusion a second time. Any gain that exceeds the exclusion will be subject to a long-term capital gains tax. For most individuals, the tax rate is either 15% or 20%. However, some or all of the capital gains could be taxed at 0% if your 2022 taxable income is equal to or less than $41,675 for single filers or $83,350 for joint filers.

Gift Tax Exclusions

In lieu of selling your home, you are entitled to an annual exclusion amount should you decide to gift your home. The annual exclusion is capped at $16,000 per person for tax year 2022 or $32,000 total for you and your spouse. In the event you and your spouse gift a home to your child and the child’s spouse, the total annual gift amount that can be excluded is $64,000 for tax year 2022. Gifts that exceed the annual limit are reported to the IRS by filing a gift tax return.

Qualified Personal Residence Trust

IRS special rules allow you to transfer your home to a named beneficiary at a future date through a Qualified Personal Residence Trust (QPRT). In a QPRT, you agree to transfer your house to the trust but you retain full control over the house. This includes the right to live in the residence and a right to sell the property. At the end of the term specified for the trust, the trust terminates and transfer to the named beneficiary is completed. A gift tax return must be filed in the year the residence is transferred to the trust. Because the gift portion of the transfer is a future interest gift, the annual exclusion from gift tax does not apply. However, you have the ability to shelter over $12.06 million (as of tax year 2022) of taxable gifts during a lifetime. Provided you haven’t already used all of your lifetime taxable gifts exemption, you can apply it to the QPRT transfer and no gift tax will be due.

Home values, beneficiaries, and lifetime estate and gift exclusions all impact downsizing decisions. Establishing a financial purpose as part of your retirement will help protect your assets and help lower your tax liability.