The government wants you to win a free house!
I caught my wife on the computer this past week. She was entering a contest sponsored by the HGTV network. Apparently, they have a grand prize drawing coming up next month that someone will win -- the prize being a $2-million package which includes a house, an SUV, and $500,000 in cash. "Great," I told her, "but how are you going to pay for it if you win?"
This comment drew an insulting look of incredulity. "What are you talking about? They give you the house and a half a million dollars. You don't have to pay for it."
"Really?" I asked. "Why don't we sit down, and I'll reveal to you just how Uncle Sam plans to participate in your great fortune if you happen to win this prize package?" Reluctantly, with a heavy sigh, she agreed to watch my presentation, her look now changing to scorn.
"Let's assume that the package valuation as given by the sponsor is $2 million." I began to put the numbers on paper. "Uncle Sugar is going to say that you have now just earned $2 million in income, and you have to pay taxes on it."
"Wait!" she exclaimed. "It's a prize, not income!"
"Surprise! Not according to the IRS. So, you're going to have to pay taxes of roughly 35%-40% on that income, so plan on writing a check to the IRS for at least $700,000."
"That's not fair, but okay, we still have the $1.3 million remaining."
"That's true, but the $500,000 the sponsor gives you in cash is still going to be $200,000 short of paying the federal taxes. How do you propose you come up with that extra tax money?"
"Well, we could take out a mortgage on the house, but with the new lending standards and restrictions, we probably couldn't qualify for a mortgage."
"That's right. Plus, with what I'm about to show you, you'd have to borrow far more than just the $200,000, so the only other option is to sell the property. Now, considering that the real estate market is overpopulated by short sales and foreclosures, the odds of getting the full value of the house at sale are highly unlikely. Let's assume that you get $1.3 million for the house at a sale (the sponsor values it at roughly $1,450,000). You need to subtract about $100,000 in closing costs, so you'll net about $1.2 million, right?" She nodded.
"Okay, so you take the $1.2 million net and use $200,000 to pay the rest of the federal tax bill."
"See" she said, jubilantly. "We now have a million dollars left over. I want to buy some more shoes!"
"Not so fast," I cautioned. "Now that you've sold an asset that you've held for under a year, you're going to have to pay short-term capital gains tax on the recognized profit -- which in this case is the full $1.2 million, as your acquisition cost was zero." (I realize that the tax calculation is on net gain, so closing costs of $100K would be subtracted, but I didn't want to confuse matters too much.) "So, if the president's new plan to impose a millionaire's tax increase to 30% on capital gains is passed, you'll owe your Uncle another $360,000 in capital gains tax."
"But wait!" She was yelling now. "We just got taxed on the $2 million, and now I get taxed again?" I nodded and covered my ears for the ensuing tirade that was sure to come.
"Okay, so now we just get to see...what? Six hundred and forty thousand dollars out of the prize?" she asked. "That's not so bad. It's better than a poke in the eye with a sharp stick," she chuckled. "I can still get matching purses for the shoes."
"Honey," I said as I gently patted her shoulder. "We're not done yet. What if we're residents of California? The state, just like Uncle Sugar, deems that wonderful prize as income, so they're going to make you pay a minimum of 10.3% on that income (and I believe that California either has bumped it to 12% or is contemplating it), which means you'll owe the state at least another $206,000. So now you're going to recognize only about $434,000 of the $2 million that you won.
"But," I continued, "it gets better. In California, short-term capital gains are taxed as ordinary income, so the $1.2 million that you got for the house requires that you pay the state of California another $123,600 in capital gains taxation. So the bottom line is out of the full $2-million prize, you would, if you could sell the house in a timely fashion, net only about $310,400."
I continued. "If you did win this prize, I would have to demand that the house immediately be donated to a charity."
"Why? It's my house!"
"The only way we could afford this would be to give it away. Let me show you: first, you're still going to have the federal and state income tax responsibility for the $2-million prize. But if you donate the house, you get to write off the full value of $1,450,000 on your taxes, so your net taxable income would be reduced to $550,000, or roughly $250,000 combined for federal and state taxes (I have never donated anything this large, so I am assuming that you get the full credit off of income here). Now you could take the $500,000 that the sponsor gave you as part of the prize and subtract out the $250,000 in taxes, and you end up netting $250,000 without having to go through the motions and complications associated with selling an expensive house in this market -- where very few can qualify."
My wife hurriedly started pounding on the keyboard. "What are you doing?" I asked.
"I'm trying to rescind my entry. I don't need new shoes that badly, and it appears that the only ones who win here are the government and the state of California!"
Thus ended my lesson in taxation in America. I then took the opportunity to remind my wife that this is precisely how Mitt Romney feels when the media attacks him for paying only 14.9% on his income. People seem to forget that he had to earn that money first, which cost him probably 35%. Only after that deduction was he able to have "net funds" to invest. It is those investments that provide the income at which he is taxed at 14.9%.
America: what a great place to win a prize (or be a high wage-earner)__PLACEHOLDER__!