Congress periodically revises the rules for figuring taxes on gains realized from sales of personal residences. A key change liberalized and simplified the rules for sales after May 6, 1997 -- the date the legislation took effect.

Gone are the rules that allowed sellers to defer taxes on their past gains only if they met these requirements: (1) purchased a replacement residence costing more than what was received for the one sold; and (2) did so within a period spanning two years before and after the sale. Alternatively, those selling after attaining age 55 could permanently exclude up to $125,000 of gain without buying another dwelling.

What the home-sale rules now generally allow is an “exclusion,” meaning escape from taxes, on a profit of as much as $250,000 for those who file single returns and double that amount -- a full $500,000 -- for joint filers.

Remember, that's profit, not sales price.

Contrast the old requirements with the new ones, which are unconcerned with how old the sellers are or whether they buy cheaper replacements or even go into rentals. Unlike the old once-in-a-lifetime exclusion, the new exclusion is not a one-time opportunity. Homeowners get to claim the exclusion as often as every two years, provided they pass these tests: (1) owned and lived in the property as a principal residence for at least two out of the five-year period ending on the sale; and (2) at least two years have elapsed since last using the exclusion.

Sellers with passing grades reap a phenomenal break that relieves the vast majority of them of all capital-gains taxes on sales of their principal residences, whether houses, condos, or co-ops. That’s the good news. The bad news is a drastic hike in taxes for many sellers in costly housing markets.

As is true of most tax measures, the new exclusion helps some and hurts others. What happens after they open the envelopes? The biggest winners: people who want to sell and relocate from expensive housing markets like New York or San Francisco to less expensive areas like Tampa, Fla., or Tucson, Ariz. Also helped are sellers who become renters, perhaps because they are "empty-nesters" (folks whose children have moved out and left them with houses that are too big and too expensive to maintain), as well as those near retirement or compelled to sell because of job switches, health problems or financial setbacks.

The new exclusion is a boon to downsizers, adding flexibility to their financial planning. They can sell their dwellings for sizable gains, switch to smaller quarters and the lower maintenance expenses that go along with it, and channel their inflation-swelled profits, undiminished by taxes, into business ventures or into retirement funds to supplement Social Security benefits. Another option is to use some of the freed-up funds for gifts of money, stocks and the like, so as to shift income from themselves to family members and others in lower brackets, as well as reduce the value of assets subject to onerous estate taxes that fall due at death.

Among those with nothing to cheer about: sellers in areas where property values have increased dramatically or who have accumulated gains (profits from before May 7, 1997 sales that were sheltered under the old rules by trading up to more expensive houses) above the exclusion amount of $250,000/$500,000.

The most recent change was introduced by the 2003 tax act. It lowered the top rate for long-term capital gains from 20 percent to 15 percent, a reduction that applies to home-sale gains above the $250,000/$500,000 threshold. The cap of 15 percent applies to sales after May 5, 2003; the previous one of 20 percent applies to sales before May 6, 2003. Add to Uncle Sam’s take, state income taxes.

Published: October 6, 2003

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Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as "a leading tax professional" (New York Times), "an accomplished writer on taxes" (Wall Street Journal) and "an authority on tax planning" (Financial Planning Magazine). This article is excerpted from "The Home Seller’s Guide To Tax Savings." Law professor James Edward Maule of Villanova University praised the book as "An easy-to-read and well-organized explanation of the tax rules. Home sellers would be well advised to buy this book." To order it, go to julianblocktaxexpert.com.