With the Taxpayer’s Relief Act of 1997 there were important changes to the way real estate is taxed. Married homeowners filing a joint return are allowed to sell their principle residences at a profit of up to $500,000 without paying capital gains taxes. Single return filers can exclude up to $250,000 of gain. With this exclusion, you don’t have to purchase another home of equal or greater value within two years to defer your capital gains as the old rules required.
To qualify for the exclusion, the taxpayer(s) must have occupied the home for two of the five preceding years. The home may have been a rental property, but must have been a principal residence for two of the last five years. For taxpayers who cannot meet the two year requirement, there is a formula for giving a partial exclusion. If the gain on the sale exceeds the maximum exclusion, normal capital gains tax rates will apply. This new exclusion replaces the once-in-a-lifetime exclusion normally reserved for people over 55 years of age. It will allow a homeowner who meets these requirements to make a tax free profit on the sale of a home without having to reinvest in another home. These new rules open many new strategies for homeowners that haven’t been available in the past. This exclusion applies only to principal residences and doesn’t apply to second homes or vacation homes. Sales of these properties are treated as income-producing property to which capital gains tax rates would apply.
For instance, if a person is being transferred from a high-cost area to a lower-priced area, in the past the person would have to buy at least as expensive a home to defer gains. Now, they can make a tax-free profit, subject to the limits on the sale and buy down and incur no tax liabilities. Another example might be a person who has a large gain in a rental property might convert it to a principal residence for two years and sell it and only pay tax on the depreciation recapture. A couple of examples follow.
| Sale of a Principal Residence by Married Couple Filing Jointly - Example #1 | Sale of a Principal Residence by Married Couple Filing Jointly - Example #2 | |||
| $ | $ | |||
| Purchase Price | 100,000 | Purchase Price | 100,000 | |
| Plus Purchase Costs | 5,000 | Plus Purchase Costs | 5,000 | |
| Acquisition Basis | 105,000 | Acquisition Basis | 105,000 | |
| Plus Capital Improvements | 25,000 | Plus Capital Improvements | 25,000 | |
| Adjusted Basis | 130,000 | Adjusted Basis | 130,000 | |
| Sales Price | 800,000 | Sales Price | 350,000 | |
| Less Adjusted Basis | 130,000 | Less Adjusted Basis | 130,000 | |
| Gain on the Sale | 670,000 | Gain on the Sale | 220,000 | |
| Less Exclusion | 500,000 | Less Exclusion | 500,000 | |
| Taxable Gain | 170,000 | Taxable Gain | 0 | |
| Times Max Tax | 28% | Times Max Tax | 28% | |
| Tax Due | 47,600 | Tax Due | NONE | |
