Home sellers have a tremendous tax break: Married couples filing jointly can exclude from their taxable income up to $500,000 of the profit they made on the sale of their house, and taxpayers filing separate returns can exclude up to $250,000.
Although this sounds simple, we all know that nothing in the tax laws can be that easy. To get the write-offs above, there are two important qualifications:
- You must have owned and used the home as your principal residence for two out of the five years before the sale. If you are married, so long as either spouse meets this requirement, the exclusion of gain applies. Marital status is determined on the date the house is sold.
- The exclusion is generally applicable once every two years. However, if you are unable to meet the two-year ownership (and use) requirements because of a change in employment, health reasons or unforeseen circumstances (which will ultimately be defined in regulations to be issued by the IRS), then your exclusion is pro-rated. These pro-rations are complex, and have caused considerable confusion among lawyers, taxpayers and even the IRS.
This new law applies to all principal residences: single family homes, cooperative apartments, and condominium units. If you claim your mobile home or your boat as your principal residence, the law is also applicable. However, in order to qualify as a residence, three things are required: sleeping quarters, a toilet, and cooking facilities.
Prior to May 6, 1997 (when the Taxpayer Relief Act of 1997 was signed into law by President Clinton), the rules were different.
We had the once-in-a-lifetime exclusion of up to $125,000 for homeowners who were over the age of 55, and we had the roll-over. The roll-over allowed the homeowner who sold his/her house to defer -- not avoid -- paying capital gains tax, if the price of the new home was equal to or greater than the selling price of the older house..
While the new $250/500,000 exclusions appear to be a good deal, there is one important fact to remember when calculating the profit you have made. Real estate in many areas appreciated dramatically in the 1960s, 1970s and most of the 1980s. Many homeowners realized the "great American dream" over the years, and continued to sell and "buy up." The profit that was made on each sale was deferred under the roll-over concept. When you sell your last house, you can exclude up to $500,000 of profit, but you have to look carefully at all of your numbers.
Let us take this example: in 1968, you purchased a house for $50,000. In 1975, you sold it for $150,000, and purchased a new house for $225,000. For purposes of our example, we will ignore such items as home improvements and real estate commissions, although these are expenses which can -- and should -- be taken into consideration in determining profit. Because you deferred $100,000 of profit ($150,000 - $50,000), the basis in your new home is only $125,000. You determine your basis by subtracting the profit from the purchase price (i.e. $225,000 - 100,000).
In 1996, you sold your home for $400,000 and purchased a new house for $500,000. Now, because of the roll-over, you have deferred profit of $275,000 ($400,000 - 125,000). The basis of your new $500,000 is now only $225,000. You will no doubt question this number, which we are using as your basis, since you purchased your second house for $225,000. But because the basis of that house was only $125,000, profit is computed by subtracting the sales price from the basis of the house (and not just its purchase price).
Here is where the problem starts. If, for example, you plan to sell your house next year, you must calculate and fully understand your basis. If you are married and file a joint tax return (and have lived in the house for at least two out of the past five years), you will not have to pay any capital gains tax unless you sell your house for more than $725,000. But, if your spouse has died, and you are now filing only a single tax return, you can only shelter up to $250,000 of profit.
Thus, even if you sell the house for what you paid for it -- namely $500,000 -- you have made a profit in our example of $275,000, and will have to pay capital gains tax on $25,000 worth of profit. The new law has a 20 percent rate, and the federal tax will be $5,000.
It must be pointed out that this example is only to explain the concept of "basis." Actually, in our example, the surviving spouse will be able to take advantage of the "stepped-up" basis (the value of the property on the date of death), and the surviving spouse will probably not have to pay any capital gains tax. But this is the subject of another column.
Thus, as you can see, it is critical to keep all of your records and all of your settlement sheets. Such expenses as home improvements, real estate commissions, fix-up costs, legal and title costs, will reduce your basis -- and thus reduce your tax. If you are ever audited by the IRS, you will be required to produce proof of these expenses.
If you sold your principal residence in 2000, and if your profit was less than $250,000/500,000,you no longer have to report the sale on Form 2119. But if your profit exceeded these dollar caps, then sales must now be reported on Schedule D of Form 1040 .
The IRS has published proposed rules attempting to interpret the new real estate tax exclusions, and hearings on these proposals were held this past week. There are a number of examples contained in the proposed regulations. Here are two interesting situations:
- Taxpayer C lived in a townhouse that he rented from 1993 through 1997. On January 1, 1998, he purchased the property. One month later, he moved into his daughter's home. On March 1, 2000 -- while still living with his daughter -- he sold the townhouse. He can exclude up to $250,000 of his gain (assuming he files a separate tax return), because he owned the house for at least two years out of the five years preceding the sale, and he used the house as his principal residence for at least two years. This is interesting, since his use was during a time when he was only a tenant.
- Taxpayer A purchases a house that she uses as her principal residence. Twelve months after the purchase, A has to change her place of employment and sells the house. Under the law, since A has not owned or used the house for two years, she cannot exclude up to $250,000 of the gain. However, since the sale was required because of a change in employment, she is eligible to exclude up to $125,000 of the gain (12/24 x $250,000).
This allocation is based on a formula, called "reduced exclusion". If the sale of the house is required by a change in place of employment, health or other circumstances to be permitted by the IRS, the reduced exclusion is computed by multiplying the maximum dollar limitation of either $250,000 or $500,000 by a fraction. The numerator of the fraction is the shortest of the period of time that the taxpayer used the property during the five-year period ending on the date of the sale. The numerator may be expressed in days or months.
Stay tuned. The IRS will ultimately issue their final regulations -- hopefully before we have to file our 2000 tax returns.
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