Understanding Capital Gain Taxes on Your Personal Residence
(About the Tax Reform Act of 1997)
The good news is that most home sellers can keep substantial profits – tax free. We can say this because most sellers of a principle residence have lived there at least 2 of the last 5 years before they sell.
Federal tax rules for avoiding capital gains tax on the profitable sale of your principal residence after May 7, 1997 were greatly simplified and made much more generous with the Tax Reform Act of 1997.
As many already know there is no longer any minimum age requirement for a tax exemption or requirement for buying a replacement principal residence of greater value within two years. But there are a few new things you should be aware of and a few easy rules for claiming up to $250,000 home-sale tax-free profits (up to $500,000 for a married couple filing jointly). The best news is that this tax exemption can be used over and over again without limit. But it cannot be used more frequently than once every 24 months.
If you are serious about taking full advantage of these tax exemptions you should consult with tax and real estate professionals and plan well in advance of selling your principle residence. Below is some very useful information that may help you understand some of your options.
How to Qualify For the Full Exemption - To qualify for the $250,000 or $500,000 exemption, Internal Revenue Code 121 requires the home to have been the seller's principal residence an "aggregate" two of the five years before its sale. The two years need not be continuous.
If a husband and wife claim the exemption up to $500,000 and file a joint tax return for the year of the sale, both must meet the two-year occupancy test (the IRS has some very specific criteria they look for to satisfy this test), though only one spouse need hold the title. However, when two or more unmarried persons each claim their $250,000 exemption, each must hold title and meet the aggregate two-year principal residence occupancy requirement. If title is held in a living trust, new IRS regulations clarify the full tax exemption is still available. Contrary to widespread misunderstanding, the home can still qualify for the tax exemption even if the owner doesn't occupy it at the time of sale. The home also need not be owned for five years – just a minimum of two years as the principle residence. For example, if you lived in your principal residence for two years and then rented it for up to three years to tenants before selling, you can still qualify. Just be sure to keep track of the date you moved out. Otherwise, your failure to sell within the next three years could cost you the tax on as much as $500,000 of capital gain.
Must Sell in Less Than Two Years? You May Qualify For a Partial Exemption - If the principle residence is sold at a profit with less than two years of owner-occupancy, a partial exemption may be available under special circumstances. The IRS recently added this partial home-sale exemption for seven "unexpected reasons": (1) death of the homeowner, spouse, co-owner or family member; (2) divorce or legal separation of an owner; (3) job loss qualifying for unemployment compensation; (4) change of employment with insufficient income to pay the mortgage or basic living expenses; (5) multiple births from the same pregnancy (such as triplets); (6) damage to the home by terrorism, war or disaster; and (7) condemnation of the home by a government agency.
For most homeowners, even a partial exemption is more than enough to eliminate any tax on a sale. The exemption is applied to your capital gain (net of commissions and closing costs) on the sale, not to the sale price. Here’s an example: Let's say that, as a single individual, in order to take a more-distant job, you sell your home after living in it for just six months and you realize a $40,000 gain. Since six months is 25% of the two-year residence requirement, you might think you could exempt 25% of your gain, or $10,000. The correct exemption, however, is 25% of $250,000, or $62,500. In other words, although the property has been your home for only six months, your entire $40,000 gain is free of tax. This may sound like short-term capital gain; but it’s not with regard to the exempted portion. The different tax rates affect only the capital gain, if any, in excess of the exemption.
If you do not qualify for the above partial exemption note that the gain on the sale of property held less than one year is considered “short term capital gain” and is taxed at the seller’s ordinary federal income tax rate. If the property is held more than one year it is “long term capital gain” and the federal tax (not including State Tax) can be up to a top rate of 20% (for those in the 15% tax bracket the gain is taxed at 10%). Yes, there are State Taxes to pay also.
A New Special Provision For Military Families - Under normal conditions the five-year provision shouldn't be a problem. But suppose you're serving on active duty far from home, as a member of the Armed Forces or the Foreign Service, and your spouse moves in with family and rents the principle residence for income. Time passes, and the exemption may be forfeited. Now, the Military Family Tax Relief Act extends the five-year period (for up to a maximum of 10 years) while the owner is on active duty. The provision is retroactive, and covers sales after May 7, 1997. Tax-refund claims filed up to Nov. 11, 2004 -- the provision is in effect for just a year -- will be honored without regard to the usual time limits.
Look Out – The Old Rules Can Still Catch Up With You - Profits deferred under the old rules on sales completed up to May 7, 1997, can still catch up with you. If your gain on a sale(s) was deferred the by purchase of your present home, its tax basis must be reduced by the amount of that gain. Form 2119, attached to your income-tax return for the year you bought your present home, contains the necessary information.
Good and Bad News For Surviving Spouses - IRC 121 has a special rule for surviving spouses. He or she can claim up to $500,000 principal residence sale tax-free profits if the home is sold in the year of the other spouse's death. If the home is sold in a tax year after the spouse's death, the exemption reverts to $250,000. This rule, seemingly forcing surviving spouses to sell their homes in the year of a deceased spouse's death to claim the $500,000 tax break, isn't as bad as it sounds. The reason is the surviving spouse, who presumably inherited the deceased spouse's half of the residence, gets a partially stepped-up residence cost basis to market value on the date of death. The result is a greatly reduced capital gain upon sale.
In the 10 community property states (California is one of them), the surviving spouse's new basis is usually fully stepped up to market value on the date of death, so there is little or no potential taxable profit after one spouse dies.
Divorced and Separated Couples Enjoy a Special Benefit - The pre-1997 tax law was very unfair when one ex-spouse was granted possession of the family home, usually until the youngest child became 18 or 21 and the jointly owned home was sold. The ex-spouse living in the home could usually avoid tax on the sale, but the ex-spouse not living in the home unfairly owed tax on their profit share.
IRC 121 is much better. If the ex-spouse living in the principal residence qualifies for the $250,000 exemption, then the ex-spouse not living in the home (called the "out-spouse") also qualifies for up to $250,000 tax-free sale profits even if that spouse doesn't meet the occupancy test.
How to Avoid Tax if Your Home Sale Profit Exceeds $250,000 (or $500,000 for a married couple) - With the rapid escalation in home values during the last few years in many communities, many potential homeowners will have sale profits exceeding the $250,000 or $500,000 exemptions.
The best way to avoid tax on the profit above the exempt amount is to convert your personal residence to rental status before selling. Then, regardless of the sale profit amount, your former personal residence becomes eligible for an IRC 1031(a)(3) tax-deferred Starker exchange for another investment or business property of equal or greater cost and equity.
There is no minimum rental time before the converted former personal residence becomes eligible for a tax-deferred exchange. Many tax advisers suggest renting for at least six months before selling as part of an exchange, but the tax law is unclear.
However, the property acquired in the exchange must be held for investment or business use and of equal or greater value. But there is no prohibition against later, perhaps after a year, converting that property back into your personal residence.
Summary - Knowledgeable principal residence and vacation home sellers can avoid and/or defer federal capital gain tax by careful advance planning. Consultation with your real estate and tax professionals is strongly suggested to take maximum advantage of the IRC 121 $250,000 or $500,000 principal residence sale tax exemption and several lesser-understood special provisions benefiting taxpayers in special situations.
This article is provided for informational purposes only. Do not consider this information as tax advice.
Rules and provisions can change over time so ALWAYS seek current information and guidance from tax professionals.
This article was compiled from several independent sources: 1) The Standard-Times on January 18, 2003, 2) Article published in Barron’s by: Mr. Gelband, tax lawyer in Larchmont, N.Y., 3) Advice from our own CPA and real estate tax expert. Curt chivers