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.
The Taxpayer Relief Act of 1997 terminated both the rollover and the once-in-a-lifetime exemption, which were the existing tax benefits at that time. 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 conditions:
●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 you must meet the “occupancy” test. Marital status is determined on the date the house is sold. In the event of a divorce when 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.
●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 Internal Revenue Service has issued regulations that 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 having to sell because you got a new job at least 50 miles farther from your home than your current location, your doctor recommends a change of location for health reasons for the treatment of a disease or you encountered unforeseen circumstances, such as a divorce or natural disaster.
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 two full years. If you are single — or do not file a joint tax return — change the $500,000 to $250,000.
This 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 toilet and cooking facilities.
While the new $250,000/$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 to 1997. 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 rollover 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.
Here’s an example: Let’s say 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. Based on the old rollover concept, you deferred $100,000 of profit ($150,000 minus $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, again, because of the rollover, you deferred profit of $300,000 ($400,000 minus 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.
What if your spouse has died? If you do not remarry before the house is sold, the IRS takes the position that you have owned and lived in the property (the “use and occupancy” test) during any period when your spouse owned and lived in it. And even if you are now filing a single tax return, you still can exclude up to $500,000 of your gain if you have not remarried; the sale takes place no more than two years after your spouse’s death; you and your spouse met the use test at the time of death; you or your spouse met the ownership test at the time of death.
So, for those of us who bought our principal residences many years ago and took advantage of the appreciation over the years, we may have to pay capital-gains tax, even after we take advantage of the appropriate exclusion. Currently, the federal tax rate is 15 percent, and depending on the jurisdiction in which you live, you may also have to pay the local state tax. For example, in the District, it is 9.9 percent.
For more information and instructions on how to handle these tax issues, go to the IRS Web site, irs.gov, and download Publication 523 called “Selling Your Home.”
Benny L. Kass is a Washington lawyer. This column is not legal advice and should not be acted upon without obtaining legal counsel. For a free copy of the booklet “A Guide to Settlement on Your New Home,” send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036.