Selling your home and moving into another one is seldom an easy decision. But, recent tax law changes might make your decision a little more profitable. As part of the Taxpayer Relief Act of 1997, Congress included a provision that will eliminate (not defer but eliminate) the federal income tax liability on the gain on the sale of a principal residence, for most people. We'll look at this provision in detail and discuss the planning opportunities available to you that may allow you to slash your income taxes.
Under the new law, generally effective for property sales after May 6, 1997, up to $250,000 of the gain from the sale of a single person's principal residence is tax-free. That's right -- tax-free. And, for certain married couples filing a joint tax return, the amount of tax-free gain doubles to $500,000. TAX FREE!
This law replaced the old personal residence sale rules. No longer do you have to "roll over" or "buy up" in order to defer your gain to a later tax year. You also no longer have to concern yourself with the "over-age-55, once-in-a-lifetime" rules regarding the exclusion of $125,000 of your gain. All of the old rules are effectively out the window (with some minor exceptions that we'll discuss in detail in Part II).
The rules allowing you to take your home sale profits tax-free apply regardless of your age and regardless of how many homes you might sell in the future or have sold the past. It is available to you even if you previously took a "once-in-a-lifetime" exclusion. As long as you meet the qualifications, this exclusion is available for you. Right now.
Example #1: Sam, age 31, sold his personal residence this year for $130,000. Sam originally bought this residence in 1994 for $85,000. Sam's gain on the sale of his principal residence in the amount of $45,000 is excluded from tax, and Sam can use these funds however he sees fit. He doesn't have to buy another home and he doesn't have to be over age 55.
Example #2: But, Sam decides to purchase another home, and closes escrow on the new home in August of this year. His purchase price was $110,000. In October, two years later, Sam sells this new home for $160,000. The $50,000 gain on the sale of this home is also excluded from tax. No tax to be paid whatsoever. In effect, over a matter of just a few years, Sam has managed to take $95,000 in home sale profits tax free.
And remember, the new exclusion rules will apply even if you previously qualified for and took your "once-in-a-lifetime" tax exclusion on a prior home sale.
Example #3: Jack and Jill sold their home for $265,000 in January of this year. They originally purchased this home in 1991 for $185,000 using the proceeds from a previous sale that took place in 1990. On the 1990 sale, they took the "once-in-a-lifetime" exclusion since they were over age 55 then and met all of the other qualifications. Jack and Jill are still able to exclude the $80,000 gain on the sale of their current residence. The fact that Jack and Jill used the "once-in-a-lifetime" exclusion in the past does not prohibit them from using the current tax laws to exclude their gain on the most recent sale.
Finally, remember that any gain in excess of the exclusion amount WILL be subject to taxation, and there is nothing you can do to get rid of that taxation. You cannot "roll over" any gain into a new residence, because those prior "rollover" rules are no longer applicable.
Example #5: Janet bought her home in 1961 for $25,000. Over the years, Janet paid $45,000 for improvements to the property (new laundry room, new roof, updated kitchen, etc.). Janet sold her home this year for $365,000. Janet can exclude $250,000 of her total gain of $295,000 but, she must pay tax on the $45,000 gain in excess of the exclusion amount. And, there is nothing that she can do to otherwise defer or exclude that portion of the gain. While the gain will be subject to the new, generous capital gain rules, Janet must still "belly up to the bar" and fork some tax dollars over to Uncle Sammy.
Like virtually all other tax laws, there are some restrictions. This exclusion has a detailed set of rules that must be followed to qualify for the exclusion. Besides the $250,000/$500,000 dollar limitation noted above, the seller must have owned and used the home as his or her principal residence for at least two years out of the five years before the sale. And, while the two years don't have to be consecutive, in most cases you can only take advantage of this gain exclusion provision once during a two-year period.
In Part II, we'll discuss these restrictions in greater detail. But, also feel free to take a look at IRS Form 2119 and the associated instructions and/or IRS Publication 17 (especially Part 3).
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