This was a CPA's tax analysis of a previous Dream Home winner. This years winner is advised to seek their own legal and tax counsel.
IMHO, this message needs to be bumped up every day. CPA/PFS...you ARE a genius!!!
Again this year, I am summarizing the income tax aspects of the Dream Home that keep coming up in various forms.
OVERVIEW
Q: What types of taxes will the Dream Home Winner (DHW) be subject to as a result of winning the Dream Home (DH)?
A: Federal income tax and State income tax of approximately $950,000 (explained below) for the year they win the DH.
Federal income tax (capital gains) and State income tax for any gain above their basis  for the year they sell it, if they do.
Real Estate taxes annually  each year. We donÂt have an exact amount, but it would be reasonable to estimate they will exceed $30,000 annually  and could be substantially more.
FEDERAL INCOME TAX
Q: Will the DHW have to pay federal income tax on the DH?
A: Yes. Parsing words will not change this. It is futile.
Q: What are the values that the DHW will be taxed on?
A: The Approximate Retail Value (ARV). HGTV estimates them to be
 $1,750,000 for the DH
 $138,000 for the DH furnishings
 $55,000 for the GMC Yukon
 $250,000 cash
 $1,450 for the Doggy DH
The total is approximately $2,194,450.
LetÂs round it to $2,200,000 because the ARV will likely increase by the transfer date.
Additionally, you will have income of $6,500 for the travel expenses, which will be taxable income but you should be able to write most of them off against the allowance.
The variable is the valuation of the DH. The preliminary estimate by HGTV is $1,750,000 as of Nov 2005. I do not know what it is valued for property tax roles, but in the past that has been higher than the ARV. The actual value will be determined at the date of transfer, which should vary upwards from the $1,750,000. I suspect the DHW will use the HGTV valuation which will be used on the 1099 and would likely not be challenged by the IRS, especially if the DHW sold it within a year  which makes the valuation differences effectively moot.
Q: How will HGTV report the DHWÂs winnings to the IRS?
A: HGTV will send the DHW a 1099 Â letÂs assume it will be for $2,200,000. The DHW will report it on Sch B as miscellaneous income.
Q: Will HGTV withhold the income tax from the winnings?
A: No. There is no requirement for them to do so.
Q: Gambling winnings, lottery winnings, etc. have withholding  why doesnÂt HGTV and the DH?
A: Because the entry if free. If you pay for the entry, such as buy a ticket or place a bet, then winnings over $5,000 require 30% withholdings. Entry for the DH is free, therefore HGTV is not required to withhold income taxes. Even if they did, it only prepays the income tax due  and doesnÂt impact the amount that is due.
Q: Roughly, how much federal income tax will the DHW have to pay?
A: Be safe and assume 35%, which is the maximum. Yes, some of it will be taxed at lower brackets, but there are too many variables among the MBers  such as current income, marital status, etc. At this level, the difference in nominal.
With an ARV of $2,200,000, the maximum federal tax the DHW will owe on the DH is $770,000 (35%). If the DHW was married and had $100,000 in other earnings, the tax on the DH would be $760,136. You see, at this level, the marginal tax rate doesnÂt really vary. LetÂs call it $770,000.
Q: When will the federal income tax be due?
A: April 16, 2007. As long as you pay as much estimated tax and withholding during 2006 as your taxes were in 2005 there will be no penalties for underpayment prior to April 16, 2007.
Q: Will the DHW have to pay the income tax before they can take possession of the DH?
A: No.
Q: If the DHW doesnÂt pay the taxes on April 16, 2007 Â what will happen?
A: First, they can get extensions to file until Oct 15. Interest and penalties for late paying will start on April 17 though. If they do file a return, but canÂt fund the taxes  over the subsequent months the IRS will send tax deficiency notices  and ultimately a tax lien if necessary. They will then try to work out a payment plan with the taxpayer. This entire process can take many months or a year. Note though, penalties and interest accrue during the delinquency period and frankly they compound quickly. Only when they have exhausted all options would they begin court proceedings to foreclose.
Q: What if the DHW is a U.S. resident (contest requirement) but not a U.S. citizen (not a contest requirement). Will they still have to pay income tax?
A: Yes. Earnings in the U.S. are taxed regardless of citizenship.
Q: What if the DHW has HGTV pay the $250,000 directly to the IRS and not the DHW?
A: It would have no impact. First, they wonÂt. Even if they did, it would be paid on the DHWÂs behalf and would not alter the income taxation to them. For instance, if instead of giving you $250,000 they sent it to the IRS on your behalf, you would still be taxed on it and the IRS would treat it as a tax payment by you. Net difference  none.
Q: What if HGTV sold the DH to the DHW for only $1?
A: That would be a "Bargain Sale" and as such the DHW would be taxed on the difference between the ARV and what they paid. It is actually worse for the DHW because they reduce their winnings by the purchase price. Say HGTV sold the DH to the DHW for only $100,000. The DHW would still be taxed on the difference  $2,100,000. They used $100,000 of their after tax dollars and effectively reduced their winnings by that amount  which is counter productive.
STATE INCOME TAX
Q: Will the DHW have to pay income tax in the state they live in?
A: Yes. They entered the contest while living in their state. It matters not if the DH is located in another state.
Q: Will the DHW have to pay income tax in North Carolina?
A: Probably. They will definitely have to file a North Carolina income tax return. NC taxes non-residents on income from any source in NC. Since the DH is located in NC, you will be subject to NC income tax on the ARV, whether you ever move there or not.
Q: Will the DHW have to pay state income tax in both their home state and NC?
A: Yes, but you receive a credit for the tax paid in the lower tax state. If the NC state income tax is greater than the income tax in their home state, then they will pay only the difference to NC. In other words, the total state income tax will be the larger of the two.
Q: What is the state income tax for NC?
A: For Married Filing Jointly, NC income tax is $14,500 for the first $200,000 and 8.25% above that. So, for a $2,200,000 Â the tax would be $179,500. They would give you a credit for the income tax paid in your home state that is applicable to the DH Â so basically you will pay the greater of $179,500 or your state income tax.
Q: Does NC have a Long Term Capital Gain tax that is lower than their regular income tax rate?
A: I do not file NC tax returns, but based on my research, it appears not. NC uses the federal taxable income to calculate the state tax. On a federal tax return, the LT Cap Gains tax rate is computed after the federal taxable income.
Q: When is the state income tax deductible?
A: In the year it is paid. So, in 2007 you pay the $179,500 NC tax for 2006 Â it is deductible on your 2007 federal income tax return, filed in 2008.
COMBINED STATE and FEDERAL INCOME TAXES
Q: So what is the total State and Federal Income Tax applicable to the DH?
A: Approximately $949,500 ($770,000 Federal plus $179,500 NC). LetÂs round it to $950,000 Â because the ARV will likely increase.
Q: How will the DHW likely pay the income taxes?
A: They could fund then out of their existing assets, if they are sufficient.
The could fund them with the equity in their existing home. Assuming that DHW wanted to move into the DH, they could use the $250,000 cash and $700,000 of the equity in their existing home (if they have it) to pay the income taxes.
They could borrow them from a lending institution. The DHW could get a mortgage for whatever amount they wanted or needed.
An interest only mortgage is running anywhere from 5.15% for a 1 year interest only mortgage to 6.5% for a 30 year fixed mortgage (P&I). So the DHW would have monthly payments ranging from $429 (interest only) to $632 (30 year fixed) per each $100,000 they borrowed.
If the DHW borrowed just the balance of the income tax $700,000 ($770,000 federal tax +$179,500 state tax - $250,000 cash award) then their monthly mortgage would easily be $3,003 to $4,424 Â assuming rates had not increased. This would be considered a "jumbo loan" with new issues to resolve.
Another option is to sell the DH.
SALE OF THE DH
Q: What will be the DHWÂs basis in the DH?
A: Whatever they report on their 2006 income tax return  arguably $1,889,450 for the DH ($1,750,000 for the DH and $138,000 for the furnishings and $1,450 for the Doggy DH)  $250,000 for the cash and $55,000 for the GMC. For simplicity purposes, letÂs round the basis to $1,900,000  as I anticipate that the ARV will increase slightly by the time of transfer.
Q: What if the DHW sells the DH immediately?
A: They will still owe the $950,000 income tax (federal and state) on the ARV. If they sold the DH for $1,900,000, then there would be no additional tax. Anything they sell the DH for over $1,900,000 (after selling costs) will be taxed as a short term capital gain at 35% federal and 8.25% state. This is why the ARV is moot if the DHW sells the DH in 2006 Â it is all taxed at the same tax rates.
If the DHW immediately sold the DH for $1,900,000 net of selling costs, they would still have after tax cash of $1,200,000 ($1,900,000 sale proceeds + $250,000 cash award - $950,000 in taxes) plus the new GMC.
If the DHW immediately sold the DH for say $3,000,000 net, then they would owe additional tax of $475,000 (35% plus 8.25%) on the gain of $1,100,000. But before you feel bad for them, consider that after tax they would have $1,825,000 cash ($3,000,000 sale proceeds + $250,000 cash award - $950,000 in taxes - $475,000 additional taxes) plus the new GMC.
Q: What if the DHW lives in the DH during for a year and then sells it?
A: If the DHW owns the DH for less than 1 year, then it is the same as above. The $2,200,000 ARV is still taxed in 2006. The only difference is that the gain of $1,100,000 ($3M sale proceeds less $1.9 M basis  assuming a $3M sale) would be taxed in the year they sold it  which could be 2006 or 2007.
Q: What if the DHW lives in the DH for more than a year, then sells it?
A: If the DHW holds the DH for more than 1 year (whether they live in it or not) Â then the net sales price that exceeds the ARV is taxed as long term capital gains at 15% federal and 8.25% NC.
NOTE: It appears that NC taxes all income the same. In other words, there is not a lower tax rate for long term capital gains.
Take the example above, if the DHW owned the DH for more than 1 year and sold it for $3,000,000 net sale proceeds, then the tax on the gain would be $255,000 ($3,000,000 sale proceeds - $1,900,000 basis * 15% LT cap gain tax and 8.25% NC tax). They would have $2,045,000 cash ($3,000,000 sale proceeds + $250,000 cash award - $950,000 tax on the ARV Â $255,000 tax on the gain) plus the new GMC.
Q: What if the DHW lives in the DH for 2 years then sells it?
A: If the DH was their principal residence and they lived in it for 2 years, then $500,000 of their gain could be tax free. A married couple can exclude $500,000 and a single person can exclude $250,000.
Using the DH as a vacation home, rental property, etc. would not qualify. You would have to establish residency at the DH. If the DH was not your principal residence, then the gain would be taxed as LT capital gain, explained above.
Using the same example, if the DHW was married, and used the DH as their principal residence for 2 years  then sold it for $3,000,000 net, then the tax on the gain would be only $140,000 ($3,000,000 sale price - $1,900,000 basis - $500,000 exclusion * 15% federal and 8.25% NC). They would have $2,160,000 ($3,000,000 sale proceeds + $250,000 cash award - $950,000 tax on the ARV - $140,000 tax on the gain) plus the new GMC.
What if after 2 years as a principal residence  the DH was sold for $4,000,000 net sale proceeds. Then the DHW would have cash of $2,928,000 ($4,000,000 sale proceeds + $250,000 cash award - $950,000 tax on the ARV - $372,000 tax on the gain) plus the new GMC.
As you can see, the variations are endless  and all good.
CHARITY
Q: What if the DHW gives the DH to charity?
A: The major problem is that while you would get a charitable deduction for the ARV ($1,900,000), only 20% of the deduction can be used against your income in any year. The rest can be carried forward for 5 years. So, in essence, you would still have to pay income tax on 80% of the DH winnings. Â or roughly $1,520,000 Â and you no longer even have the DH. This makes this option unattractive.
Before anyone gets confused, most people consider the charitable deduction to be 50% of Adjusted Gross Income (AGI). That is the rule for cash gifts to public charities. Non cash gifts to public charities is limited to 30%. Gifts of short term capital gains property (which is what the DH would be for the first year) is limited to 20%.
Another problem is charitable contributions are preference items for Alternate Minimum Tax  which could result in even higher taxes.
Q: What if the DHW claims they entered on behalf of charity?
A: The problem is that the HGTV rules require entrants to be residents of the U.S. A charity fails that. As such, even if the DHW immediately tried to give their rights to a charity, the tax laws would consider that an assignment of ordinary income and the DHW would be taxed on the winnings and allowed a charitable deduction  which is addressed above.
Q: What if the DHW gives the DH to a Charitable Remainder Trust (CRT)?
A: In a CRT, the donor gets income from the CRT and at some point the CRT assets transfer to a charity. This only magnifies the problems. You would still owe the income tax as explained above, the charitable deduction would be much lower, probably less than 20% of the ARV, and new issues would arise such as how the CRT would generate cash to distribute to the donees. This solution has significant practical problems for this type of property.
Q: What if the DHW gives the DH to a Charitable Lead Trust (CLT)?
A: This is the reverse of a CRT. A charity gets income for a set period and then the assets of the CLT transfer  typically to benefit your children. Even though this was touted as an option in newspaper articles in prior years  it is simply not viable. The articles are incomplete, misleading and inaccurate. You would still owe at least 80% of the income tax in 2006  you would have reduced the charitable deduction significantly  and you would have created a new, real problem. How is the CLT going to generate cash to distribute to charity. They are required to distribute at least 5% of the value of their assets annually. If they could get HOA approval, they could rent the DH. New problem, as the donor, the DHW is a "disqualified person" and cannot rent the DH from the CLT. Neither can their parents, children, etc. So, the newspapers in prior years were clueless when they suggested this option.
TRUSTS
Q: Can the DHW transfer the DH to a trust and avoid the income taxes?
A: No. The DHW will still be taxed on the DH. Not only that, you will have likely incurred gift tax on the transfer to the trust.
Q: Can the DHW transfer the DH to a trust and then file bankruptcy to avoid the income taxes?
A: That wonÂt work. The IRS has the legal right to follow the asset. They will file a lien and then start court proceedings. The courts will invade the trust and allow the IRS to foreclose on the transferred asset (DH). Additionally, bankruptcy does not alleviate income tax liabilities.
Q: CouldnÂt the DHW claim that they entered on behalf of the trust  and therefore the trust really won the DH?
A: Not the way I have read the HGTV DH rules. Entrants must be U.S. residents. A trust, even if a U.S. resident entered on their behalf, is not a U.S. resident. But, letÂs assume you could. You have likely increased the federal income tax liability because taxable trusts are taxed at the maximum tax rate (35%) on all income over $10,050 whereas a married filing joint doesnÂt reach the maximum tax rate until their income exceeds $336,000. Still, I think it is a moot point.
SALES TAX
Q: Will the DHW have to pay sales tax on the DH value?
A: No. It does not apply.
GIFT TAX
Q: Will there be a gift tax to the DHW?
A: No. Not when HGTV transfers the DH to the DHW. If the DHW subsequently decides to give the DH to say  their children, then the gift tax laws would be applicable. Each taxpayer can transfer up to $1 M during their lifetimes in addition to $12,000 to each recipient each year. Gifts above those amounts incur gift taxes of 46%.
ESTATE TAX
Q: Will there be an estate tax to the DHW?
A: No. Not when HGTV gives the DH to the DHW. When the DHW dies, there would likely be estate tax issues when transferring the DH to their children. Whether any estate taxes would apply would depend on their total estate and the laws in effect then. In 2006, a married couple can effectively transfer $4 M upon their deaths before incurring estate tax. After 2010, they can only transfer $2 M before they incur estate tax.
VIABLE WAYS TO FUND THE INCOME TAX
Q: What are some of the ways the DHW could fund the income taxes?
A: Fund it out of their existing assets.
Fund it with the equity in their existing home.
Borrow it from a lending institution.
Borrow it and fund it with a mortgage. View it as buying the home at 40 cents on the dollar.
Use it as a revenue source to generate the cash flow to pay the taxes or a (tax) loan payment, such a rental, etc. The deed restrictions allow a long term lease but prohibit B&Bs, etc.
Sell the DH and used the proceeds to fund the taxes, resulting in a $1,300,000 after tax windfall.
SUMMARY
The DHW will receive prizes valued at approximately $2,200,000.
In April 2007, they will owe federal and state income taxes of approximately $950,000.
They will owe property taxes annually.
Sales tax does not apply.
Gift tax does not apply  unless the DHW subsequently transfers the DH.
Should anyone feel bad that the DHW has a large tax liability? No. They just received a $1,300,000 increase in their net worth  after tax. Also, the DH is likely to have a market value substantially higher than the ARV.
