Plan Ahead to Steer Clear of Retirement's Unexpected Complications

There was a time when the city's real estate tax rate was lower than those of most surrounding jurisdictions, but as home prices soared, D.C. politicians preferred to make only a modest cut in the rate -- unlike several Virginia jurisdictions, which reduced theirs fairly sharply -- and instead limited to 10 percent the annual tax increase for homeowners. That eases the pain in the short run but leaves homeowners facing 10 percent tax rises every year until their payments catch up with the assessment.

So, what to do?

First, if we are going to move, we need to decide where.

I grew up in Virginia and had long assumed that if we moved, that's where we'd go. And we have property there. But taxes in Virginia have been climbing, especially for retirees. The top marginal rate is 5.75 percent (beginning at taxable income of $17,000 vs. 8.7 percent beginning at $40,000 for the District), but a once-generous income exclusion for seniors has been sharply scaled back. The result is that if we moved to Virginia, our income tax would drop by about a third.

Or, if we moved to Arizona, where we also have a house, it would drop by a little more than half. And of course, if we moved to Texas or Florida or one of the other no-income-tax states, state income taxes would drop by 100 percent.

This is what a lot of local retirees do -- sell and move. But we now have a very expensive house, though it was not when we bought it in 1973, so selling presents tax problems. Plus, we like the place.

But if we kept our house in the District -- as, say, a pied-à-terre -- the taxes on it would immediately double if we ceased to be residents, eating up most of the income-tax savings in Virginia, at least in the short run. We'd still be ahead in Arizona or Texas, but we'd also be in Arizona or Texas, at least most of the year. Hmm. Well, I've been in Arizona recently, and it wasn't bad. The property taxes also seemed reasonable.

On the other hand, if we sell the house, we'd end up with a lot of income tax. Homeowners can no longer roll over the profit from sale of their house into another one. Instead there's a tax exclusion -- up to $500,000 for a married couple -- on such profits. But that exclusion, which seemed so large when it was enacted in 1997, has been pretty much eaten up by the recent explosion in house prices here and in many other jurisdictions.

And a one-time big capital gain would likely bring the alternative minimum tax down on us, wiping out much of the benefit of the nominally low capital gains rates.

We could put the house into rental for a year or two, then sell it while buying another rental property. That way we could combine the homeowner exclusion with the like-kind exchange deferral allowed under Section 1031, taking our $500,000 out and using the rest to buy, for example, a condo that we could rent out. The Treasury Department specifically approved this strategy last year. We might also eventually move into the condo, but we'd have to hold it five years before we could qualify for the homeowner exemption if we sold it.

Another issue is estate taxes. We don't want to end up with large assets in several jurisdictions, possibly triggering tax in more than one state. And so much estate-tax law is now in flux, with both federal and many state laws changing or scheduled to change in the next few years. Many states, including Virginia, and the District have enacted their own estate taxes, while others have allowed theirs to expire because they were tied to a federal credit that was phased out by the tax-cut law of 2001. But the federal law is scheduled to revert to its pre-2001 form, possibly bringing back estate taxes in states where now there are none.

Of course, owning an expensive house isn't something that elicits a lot of sympathy, but with area house prices at their recent levels, mine is hardly a unique situation. According to a report in Friday's Wall Street Journal, 410 houses in the Washington area sold for $1 million or more in the first three months of this year -- and that was a 6 percent decline from last year's first quarter.

The lesson here is that if you find yourself approaching retirement age and living in a house that has greatly appreciated in value, start thinking ahead about what you want to do with it. There are a number of things you can do minimize your taxes, and planning ahead helps. On the other hand, the best-laid plans can go for naught if legislators change the law on you.

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If further evidence were needed that $1 million isn't what it used to be, a survey by the Spectrem Group consulting firm refers to those with $100,000 to $1 million in "investable assets" as merely the "mass affluent." Because investable assets account for 22 percent of these folks' total assets, many have substantially more than $1 million total. Spectrem found that when their residences are included, these people have 37 percent of their wealth in real estate, putting them "at significant risk" in a real estate market collapse.

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Where do millionaires live? On a percentage basis, it's Los Alamos, N.M., where 779, or 9.7 percent, of the community's 7,986 households qualify as millionaires, according to Phoenix Marketing International, a market-research firm. The Washington area, where 124,675 households, or 6.3 percent of just under 2 million total, have more than $1 million in investable assets, ranked 12th. Washington was one of only two metro areas with more than 1 million households -- the other was San Francisco, just ahead at 6.4 percent -- to crack the top 25 in the survey.