Tax Breaks When You Sell
Thinking of selling your home but worried about the tax implications on such a huge financial gain? You�re not the only one. In 1997, the IRS made dramatic changes to rules governing tax liability on home sales, which today, still have folks jumping for joy and scratching their heads at the same time.
The changes took place regarding a law known as the �Taxpayer Relief Act of 1997�, and provided substantial tax breaks if you meet certain requirements. The current rule states that if you have lived in your home for two of the previous five years, you can make a profit on a sale of up to $250,000 if you�re single or $500,000 if you�re married, with no federal tax bill (you will still need to pay state taxes.) This law, open to everyone, replaced the former �replacement residence� rule that allowed just a one time break from tax liability - a break of up to $125,000 on profits that was applicable to only senior citizens if they bought a replacement home.
Who qualifies?
In order to qualify for this very generous tax benefit, you must own and use your home as a principal residence for two of the five years prior to the sale. Several factors determine whether your home qualifies as a principal residence, which also apply to multiple homeowners. The amount of time each home is used, place of employment, where other family members live, address used for tax returns, driver�s license, voter registration, and bills are all considered.
When calculating the time period, the IRS means a full 24 months or 730 days! Brief retreats will not affect the time, but longer breaks, including a one-year excursion abroad will.
What are the benefits?
One of the major benefits of the current law is that you can receive the tax break as many times as you sell a home, providing you meet the time and principal residence requirements. The old law only allowed this break only once in a lifetime to those over 55, providing they bought a replacement residence.
What about previous gains?
OK, there is one hiccup to this remarkably generous tax benefit. If you have made prior home sales, any profits or gain you realized from those sales must be included when calculating your current gain. This figure is applied against the maximum amount that can currently be excluded from tax ($250,000 or $500,000 depending on marital status). Since old rules permitted us to avoid tax on gains, if we �rolled� them into purchasing a bigger home, the current laws make us account for these postponed profits.
Here is an example for more clarity on this point. Assume you�ve owned three homes over the past 25 years, and each one appreciated, or grew in value by $100,000. If each time you sold a home you bought a more expensive one, prior rules allowed you to roll profits from each home into the next. So, in this example, you may have never paid capital gains tax on the $300,000 profit from the sale of each home ($100,000 from each home). Now, if you sell your current home, and you are single, you will owe taxes on $50,000 of that profit. ($300,000- $250,000). If married, you owe no taxes on profits of up to $500,000, so you will have no tax liability in this situation.
Are there any circumstances that change the rules?
There are a few loopholes to the current law�s two-year residency requirement. If a sale is related to health or change of employment, the maximum exclusion amount is limited to the percentage of the two years that the standard requirements were fulfilled.
When death, marriage, or divorce is the reason for the sale, the two-out-of-five-year requirement must be met. If a spouse dies, the survivor can file a joint return that year and claim the $500,000 exclusion for joint filers. Following that year, the exclusion will drop to $250,000. If a surviving spouse inherits the other spouses share, the surviving spouse�s cost basis on that share is increased, or stepped up to the market value as of the date of death. This will decrease profit on a sale of the home, since the surviving spouse will not have as much capital gain with the new higher cost basis.
Newly married couples who own homes prior to their marriage are each entitled to the $250,000 break, even if filing jointly. But if one spouse has a huge capital gain on her home, it might pay to both live in that home for two years before selling, which will allow the couple the benefit of the $500,000, joint exclusion.
While very beneficial, the current rules can be a bit complicated to apply. For additional support, IRS Publication 523 has some helpful worksheets for calculating the cost of your house for tax purposes, and offers ample resources on its website (www.irs.gov). Since tax laws seem to change with the wind, future adjustments can always be anticipated. It is always recommended that you contact your tax advisor for comprehension of complicated tax issues.
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