This is a Q&A summary of the income tax aspects of the 2008 HGTV Dream Home performed by a Certified Public Accountant (CPA). The information presented on this page is intended only as a guideline to help you understand what to expect when winning mega sweepstake prizes.
FEDERAL INCOME TAX
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 probably State income tax … for the year they win the DH. Real Estate taxes annually … each year.
Federal income tax (capital gains) and State income tax for any gain above their basis … for the year they sell it, if they do.
Q: Will the DHW have to pay federal income tax on the DH?
A: Yes. If you win the DH…you will pay federal income taxes.
Q: What are the values that the DHW will be taxed on?
A: The Approximate Retail Value (ARV). HGTV estimates them to be:
… $2,000,000 for the DH
… $150,000 for the DH furnishings
… $55,000 for the 2008 GMC Yukon Hybrid
… $1,500 for the Doggy DH
The total is approximately $2,206,500. Be aware that the ARV will likely increase by the transfer date which is the date used for IRS purposes.
The variable is the valuation of the DH. The preliminary estimate by HGTV is $2,000,000 as of October 15, 2007. I do not know what 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 may vary from the $2,000,000. 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 DHW’s winnings to the IRS?
A: HGTV will send the DHW a 1099 … let’s assume it will be for $2,206,500. The DHW will report it on Schedule B as miscellaneous income. Be aware that the value must be as of the date of transfer … probably in May 2008. $2,206,500 is merely an estimate … not the actual taxable value. There is roughly 8 months time between the initial valuation date and the actual valuation date (transfer date). Expect the property valuation to increase. In the past, it has increased by as much as $500,000. The October 2007 value is an estimate … whereas the 1099 value should be based on an appraisal. HGTV will likely rely on a commercial real estate appraisal to determine the actual ARV … as there are significant penalties applicable if they are substantial under-valuations. Also, the 1099 is typically issued after the end of the year … likely January 2009 … not when the prize is awarded.
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 doesn’t HGTV and the DH?
A: Because the entry is 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 doesn’t 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 is nominal.
With an ARV of $2,206,500, the maximum federal tax the DHW will owe on the DH is $772,275 (35%). If the DHW was married and had $100,000 in other earnings, the tax on the DH would be $761,633. You see, the marginal tax rate doesn’t really vary.
Q: When will the federal income tax be due?
A: April 15, 2009. As long as you pay as much estimated tax and withholding during 2008 as your taxes were in 2007 there will be no penalties for underpayment prior to April 15, 2009.
Q: Will the DHW have to pay the income tax before they can take possession of the DH?
Q: If the DHW doesn’t pay the taxes on April 15, 2009 … what will happen?
A: First, they can get extensions to file until October 15. Interest and penalties for late paying will start on April 15 though. If they do file a return, but can’t fund the taxes … over the subsequent months the IRS will send tax deficiency notices … and ultimately file 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 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 … $2,106,500. 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, if they live in one of the 41 states with state income tax. 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 Florida?
A: No. Florida does not have a state income tax.
FUNDING THE FEDERAL INCOME TAXES
Q: How will the DHW likely pay the income taxes?
A: They could fund them out of their existing assets, if they are sufficient.
They could fund them with the equity in their existing home. They could borrow them from a lending institution. The DHW could get a mortgage for whatever amount they wanted or needed.
Mortgage rates have many variables, such as your credit rating, and change daily. But, let’s assume an interest rate of 6.25% for a 30 year mortgage. The DHW would have monthly payments of $616 per each $100,000 they borrowed.
If the DHW borrowed just the federal income tax of $772,275 then their monthly mortgage payment would be $4,756.
Another option is to sell the DH.
SALE OF THE DH
Q: What will be the DHW’s basis in the DH?
A: Whatever they report on their 2008 income tax return … arguably $2,151,500 for the DH ($2,000,000 for the DH and $150,000 for the furnishings and $1,500 for the Doggy DH) … and $55,000 if they also include the GMC. IF the ARV increases, so will the income taxes and the basis.
Q: What if the DHW sells the DH immediately?
A: They will still owe the $772,275 federal income tax (and any state income tax) on the ARV. If they sold the DH for $2,151,500, then there would be no additional tax. Anything they sell the DH for over $2,151,500 (after selling costs) will be taxed as a short term capital gain at 35% for federal income taxes. This is why the ARV is moot if the DHW sells the DH in 2008 … it is all taxed at the same rates.
If the DHW immediately sold the DH for $2,151,500 net of selling costs, they would still have after tax cash of $1,379,225 ($2,151,500 sale proceeds - $772,275 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 $296,975 (35%) on the gain of $848,500. After taxes the DHW would have $1,930,750 cash ($3,000,000 sale proceeds - $772,275 in taxes - $296,975 additional taxes) plus the new GMC.
Q: What if the DHW lives in the DH less than 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 $2,151,500 ARV is still taxed in 2008. The only difference is that the gain of $848,500 ($3M sale proceeds less $2,151,500 basis … assuming a $3M sale) would be taxed in the year they sold it … which could be 2008 or 2009.
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) … then the net sales price that exceeds the ARV is taxed as long term capital gains at 15% federal plus any state income tax.
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 $127,275 ($3,000,000 sale proceeds - $2,151,500 basis x 15% LT cap gain tax). They would have $2,100,450 cash ($3,000,000 sale proceeds - $772,275 tax on the ARV - $127,275 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 up to $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 long term 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 approximately $52,275 ($3,000,000 sale price - $2,151,500 basis - $500,000 exclusion x 15% federal). They would have $2,175,450 cash ($3,000,000 sale proceeds - $772,275 tax on the ARV - $52,275 tax on the gain) plus the new GMC.
As you can see, the variations are endless.
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 ($2,151,500), 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 … or roughly $1,765,000 … 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. 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.
In summary, giving the DH to charity is not a viable option to reduce the taxes.
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 won’t 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: Will the DHW have to pay sales tax on the DH value?
A: No. It does not apply
Q: Will there be a gift tax to the DHW?
A: No. Not when HGTV gives the DHW the DH. If the DHW subsequently decides to give the DH to say … their children, the gift tax laws would be applicable. Each taxpayer can transfer up to $1,000,000 during their lifetimes in addition to $12,000 to each recipient each year. Gifts above those amounts incur gift taxes of 45%.
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 2008, a married couple can effectively transfer $4 million upon their deaths before incurring estate tax. After 2010, they can only transfer $2 million before they incur estate tax.