01/16/07: Selling Your Home May Be Tax Free
By Benny L. Kass
(Third in a Series)
When there is an income tax, the just man will pay more and
the unjust less on the same amount of income.
Plato (427 BC-347 BC), The Republic
Your home may not always be your “castle”, but if it is your principal residence, there is one very significant tax benefit when you decide to sell. In general, if you file a joint tax return with your spouse, you can exclude up to $500,000 of your profit ($250,000 if you file a separate return).
Two real estate tax benefits — the “roll-over” and the “once in a lifetime” — are no longer with us. However, their memory will linger on, at least for some taxpayers who have made a lot of profit over the years and who were buying and selling their homes prior to l997.
The roll-over, you will recall, allowed homeowners who sold their principal residence to defer all profit if they purchased a new house within two years at a price which was equal to or greater than the sales price of their previous home. However, this was not a tax exclusion; it was only a tax deferral — which meant that ultimately you might have to pay capital gains tax when you sold your last home.
The once-in-a-lifetime exclusion, however, allowed taxpayers over the age of 55 to completely exclude from taxation up to $125,000 on the profit they made on their principal residence.
These laws applied prior to May 6, 1997. The Taxpayer Relief Act of 1997, signed by President Clinton on August 5, 1997, did not retroactively change the old laws. However, the new law did abolish both the roll-over and the once-in-a-lifetime exemption. In its place, the law substituted a more beneficial approach for American homeowners.
When you sell your home, married couples can exclude from their taxable income up to $500,000 of gain. Individuals filing separate returns can exclude up to $250,000. Unlike a deduction, which allows you to take a percentage off your gross income (based on the tax rate bracket in which you fall) the exclusion means that the profit you make up to the statutory ceiling is not even included in your income for tax purposes.
There are two important limitations:
1. You must have owned and used the home as your principal residence for two out of five years before the sale. If you are married, although both husband and wife must meet the “use” test, only one of them must meet the “occupancy” test. 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, then your exclusion may be prorated.
The IRS has issued regulations which will guide you if you are faced with having to sell before the two years are up. There are what is known as “safe harbors” – in other words, if you fall within the guidelines, you are safe to take the partial exclusion.
These safe harbors include:
– change in employment: if the primary reason for the sale is a change in the location of employment – and the new job is a least 50 miles farther from your home than your location.
– health: if your doctor recommends a change of residence, either to obtain or facilitate the diagnosis, cure or treatment of disease, illness or injury, or to obtain or provide medical or personal health care. The recommendation must be to a qualified individual, which can be the homeowner, parents, grandparents, children, in-laws or even uncles, aunts, nephews or nieces.
– unforeseen circumstances: if you could not have anticipated an event before you purchased your house, you may also be able to claim a partial exclusion. While this is fact specific – and in many cases you will have to get a special ruling from the IRS — there are some safe-harbors which the IRS will recognize. These include: an involuntary conversion of your house, natural or man-made disasters resulting in a casualty to your home, divorce or legal separation, and multiple births resulting from the same pregnancy.
If you are eligible for the partial exclusion – either because you meet the safe harbor tests or get specific approval from the IRS – this exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is 2 full years. If you are single – or do not file a joint tax return – change the $500,000 to $250,000.
This new law applies to all principal residences: single family homes, condominium units and cooperative apartments. If your boat or your mobile home is your principal residence, the law is also applicable if three things are present: sleeping quarters, a head (toilet), and cooking facilities.
While the new $250/500,000 exclusions are great for most taxpayers, there is one important fact to remember when calculating the profit you have made. Real estate appreciated prior to1997. Many homeowners utilized 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 to determine exactly what profit you made.
Let us take this example: in 1965, you purchased a house for $50,000. In 1975, you sold it for $150,000, and purchased a new house for $200,000. For purposes of 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 profit. Because you deferred $100,000 of profit ($150,000 – $50,000), the basis in your new home is now $100,000. You determine your basis by subtracting the profit from the purchase price.
In 1987, you sold your home for $400,000 and purchased a new house for $500,000. Now, because of the roll-over, you deferred profit of $300,000 ($400,000 – 100,000). The basis of your new $500,000 is now $200,000. You will no doubt question the $100,000 number, since you purchased your second house for $200,000. But because the basis of that house was only $100,000, 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 keep track 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 $700,000. 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 $300,000, and will have to pay capital gains tax on $50,000 worth of profit. Currently, the federal tax rate is 15 % and your tax will be $7,500. Depending on the jurisdiction in which you live, you may also have to pay the local State tax. For example, in the District of Columbia, it is 9.9 percent.
This is why it is so important 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 increase your basis — and thus your tax.
Once again, each taxpayer has different concerns and situations. You are advised to consult with your financial and legal advisors if you sold your house last year. You can also get some helpful information from IRS Publication 523, entitled “Selling Your Home – for use in Preparing 2006 returns.” This is available on the IRS website, www.IRS.gov.
(Next: Capital Gains tax and depreciation for investors)