“There is no such thing as a good tax.”
— Winston Churchill
Homeowners got an income tax reprieve on Jan. 1 when Congress enacted the so-called “fiscal cliff” legislation.
Home mortgage interest remains deductible, and the exclusion of gain up to $500,000 from the sale of a principal home is very much alive, even though many influential organizations, including the Simpson-Bowles deficit commission, strongly recommended limiting (or even eliminating) those two sacred tax breaks.
So let’s take a look at them.
Did you sell your home last year? Although many people in this area were underwater, property values actually increased in 2012. Under the law, you can exclude up to $500,000 of your profit if you are married and file a joint tax return, or up to $250,000 if you file a separate tax return.
You pass two important tests: You must have owned the home for at least two years during the five-year period prior to the date of sale. (If you are married, only one of you has to meet that test.) And you and your spouse must have lived in the house for at least two years. In the event of a divorce where one spouse is awarded the house, the ownership requirement will include any time accrued when the former spouse owned the property.
What if your spouse dies and you want to sell the family home? If you did not remarry, you can still qualify for the up-to-$500,000 exclusion if the sale takes place no more than two years after the death, and if you and your spouse met the use and ownership requirements at the time of the death.
But what if you have to sell and cannot pass the two-out-of-five-years test? There are some “safe harbors,” and if you meet IRS qualifications, you may claim a partial exclusion.
The qualifications include a change in employment: if the primary reason you had to sell is that your new job will be at least 50 miles farther from your current home. Another exclusion is health: if your doctor recommends a change of location, either to facilitate treatment or to provide medical or personal health care. The doctor’s recommendation can be to any qualified individuals, which can include parents, children, grandparents, even uncles and aunts.
There is a catch-all third exclusion for “unforeseen circumstances.” Examples include death, destruction of the home, unemployment, divorce or legal separation, or multiple births resulting from the same pregnancy.
The partial exclusion requires doing some math. It is equal to the number of days of use times the quotient of $500,000 divided by 730 days (which is two full years). If you are single or do not file a joint tax return, replace the $500,000 with $250,000.
Some homeowners in this area will make a profit of more than the exclusion that is allowed by law. If that’s your situation, you will have to pay capital gains tax on the amount of gain over the exclusion. Thus, it is important to make sure you have included all improvements and all legitimate expenses in calculating your tax basis. Oversimplified, the tax basis is the price you paid to buy the home plus such items as closing costs, real estate commissions and improvements.
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