Your home is your castle. In ancient times, the knights of yesteryear protected the Lords and Ladies of their castle. Congress, in l997, became the current knights, by providing significant protections for today's Lords and Ladies.

Under current tax laws, for sales of a principal residence after May 6, 1997, married couples can exclude from their taxable income up to $500,000 of gain. Individuals filing separate returns can exclude up to $250,000.

For many years, there were two tax concepts which often saved homeowners from paying a lot of capital gains tax: the "roll-over" and the "once in a lifetime". However, the Taxpayer Relief Act of 1997, signed by President Clinton on August 5, 1997, abolished both of these concepts. The roll-over and the once-in-a-lifetime exemption for homeowners over 55 years of age, are real estate and tax history.

Although there are no restrictions on the number of times this exclusion can be used (as compared to the old "once-in-a-lifetime" approach) the law does contain two important conditions:

1. You must have owned and used the home as your principal residence for two out of five years before the house is sold. 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. In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirements will include any time that the former spouse actually owned the property before the transfer to the other spouse.

2. 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 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. However, most homeowners who are required to sell their home within less than two years will probably not be fortunate to have made enough profit to be concerned about this issue.

In this connection, however, this columnist has to ask the IRS: when are you going to issue your regulations? The law was enacted in l997. The IRS issued proposed regulations attempting to clarify that law, and an IRS public hearing on these proposals was held almost one year ago today. Clearly, since l997, there have been a large number of residential homes sold throughout the country, and it is high time that the IRS finalize these very important rules.

The law applies to all principal residences: single family homes, cooperative apartments, and condominium units. If your boat or your mobile home is your principal residence, the law is also applicable. In order to qualify as such, three things are required: sleeping quarters, a toilet, and cooking facilities.

The old roll-over rules were mandatory. If your situation met the requirements, you had to take the roll-over. Under the new law, however, homeowners can opt not to use the new exclusion laws, and just pay the normal capital gains rate. There are circumstances where paying the capital gains tax may be to the taxpayer's advantage, but these questions must be discussed with your own individual tax advisor.

While the new $250/500,000 exclusions sound too good to be true, there is one important fact to remember when calculating the profit you have made, and the tax you may have to pay.

Real estate in many metropolitan areas has appreciated dramatically over the past half century. 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 old roll-over concept. Now, when you sell your last house, and you are married, 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 1966, you purchased your first house for $30,000. In 1975, you sold it for $140,000, and purchased a new house for $200,000. For this 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 your actual profit. Because you deferred $110,000 of profit ($140,000 - $30,000), the basis in your new home is now $90,000. You determine your basis by subtracting the profit from the purchase price (i.e. $200,000 - 110,000).

In 1989, at the peak of the then real-estate market, you sold your home for $400,000 and purchased a new house for $500,000. Because the roll-over was still the law, you had deferred profit of $310,000 ($400,000 - 90,000). The tax basis of your new $500,000 home is only $190,000.

Keep in mind that under the old "roll over" rules, every new home you purchased had to take into account the deferred gain which you had made on the sale of your previous home.

Here is where the tax bite may occur. If, for example, you plan to sell your house in the near future, you must calculate and be aware of 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 $680,000.

But, if your spouse has died, and you are now filing 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 will have made a profit in our example of $320,000, and will have to pay capital gains tax on $70,000 worth of profit (i.e. the excess over $250,000). The new law has a 20% rate, and the federal tax will be $14,000.

Clearly, for many older Americans -- especially where one spouse has died -- this may be unfair (although the "stepped up" basis, which is a topic for another column) will provide some measure of relief). Thus, it is absolutely critical that you 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 profit -- 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 last year, you no longer have to report the sale on Form 2119. Such sales are now reported on Schedule D of Form 1040, but only if you have to pay capital gains tax -- i.e. your profit is more than $250/500,000, or if a portion of your gain is not exempt.

Let's look at one more example: Samantha purchased a home in l997, and rented it out until June 30, 1999. She then moved into the home, and sold it in November of 2001. For the two years that the property was rented, Samantha took depreciation deductions amounting to $10,000. Her gain on the property was $120,000 (she bought it for $150,000 and sold it last year for $270,000).

Since she lived in the property for two out of the last five years before the sale, Samantha (who is unmarried) can exclude up to $250,000 of her gain. However, under the tax laws, the exclusion for gain on a sale of a principal residence does not apply to any gain that is attributable to depreciation deductions for periods after May 6, 1997. Thus, Samantha can only exclude $110,000 of gain, and has to pay capital gains tax on the $10,000 which she had previously depreciated. This is called "a recapture" tax, and the tax rate on this gain is 25 percent.

However, gain attributable to depreciation taken prior to May 7, 1997, need not be recaptured.

Clearly, if you have any unusual circumstances surrounding the sale of your residential real estate, you should do two things: (l) talk to your tax advisors, and (2) write the IRS demanding that they finalize their long-outstanding proposed regulations.

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For more articles by Benny Kass, please press here.

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Copyright 2002 Benny Kass. Posted by Realty Times with permission.

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Published: January 28, 2002

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