Am I entitled to the once-in-a-lifetime exemption under the following circumstances? In February 1986, we sold a house for net profit of $136,000. We have lived there for 35 years, and it was originally purchased for $10,000. There were many improvements and additions made to it. That same month, we purchased our present home and we reported an even-value trade to the IRS. We paid a purchase price for the new home of $110,000 and we spent more than $30,000 to correct faults in the house and to improve it in one year. When we sell this house for about $150,000, we expect to take the once-in-a-lifetime exclusion of $125,000 for people over age 55. Do we have to live in this house for five years before selling? We find it is too large and we wish to purchase a smaller, less expensive home.
I have received many letters from readers on the question of the once-in-a-lifetime senior citizen exemption. The purpose of this column is to try to give a broad overview of how the law works, and how you can use it on a practical basis.
As you pointed out, until last year, taxpayers who held their real estate for more than six months, who were ineligible for other tax benefits such as the rollover or the once-in-a-lifetime exemption, paid tax on the profit based on what used to be known as the capital gains tax. Under this approach, no more than 20 percent of the total net profit on the sale of the real estate could be taxed.
However, with the Tax Reform Act of 1986, Congress repealed the capital gains tax, and now any profit is taxed at ordinary income rates. For the year 1987, sales on real estate that generate a profit can only be taxed at a maximum of 28 percent. Next year, your tax will depend on what tax bracket you are in.
Thus, it is extremely important that you are familiar with every available tool authorized by Congress so as to defer or avoid paying the tax on your real estate investment.
The once-in-a-lifetime exemption is one such tool.
The taxpayer who has attained the age of 55 prior to the date of the sale of his or her principal residence may elect to exclude up to $125,000 of the gain realized on this sale. For married taxpayers who file separate returns, the maximum exclusion is $62,500 on each separate return.
To qualify for the exclusion, there are a number of requirements.
First, the taxpayer must be at least 55 years of age. Where a husband and wife are involved, if one spouse meets all the requirements for the exclusion, both spouses are treated as meeting the requirements.
Second, the taxpayer must have owned and used the residence as his or her principal residence for a total of at least three years during the five-year period ending on the date of the sale of the residence. It should be pointed out that for purposes of the term "residence," condominiums and cooperatives are also included.
If, for example, a person was a tenant in a property for two years, then purchased the property, if he lived in the property for only one additional year, he can still qualify for the exclusion. Ownership without personal use and personal use without ownership may be taken into consideration in determining whether the ownership and use tests are met.
And the Internal Revenue Service has also taken the position that short, temporary absences will not defeat the three-year requirement. If you take a vacation or have a seasonal absence, even if you rent the property during your absence, this still can qualify for the three-out-of-five-year use requirements.
It should be pointed out that only one lifetime exemption is available to a taxpayer. Married taxpayers are entitled to only one exemption per couple -- not one for each spouse. It should also be pointed out that if spouses elect to take the exemption during marriage and they subsequently divorce, no further exemption is available to either of them or to their future spouses should they remarry. For persons over 55 who have already taken the once-in-a-lifetime exemption, Congress seems to be putting a premium, in this context, on staying single.
The taxpayer who is over 55 whose spouse has died will be treated as satisfying the various requirements if the taxpayer is 55 or older prior to the date of sale and has not remarried, and the deceased spouse satisfied the holding and use requirements and did not previously take the exclusion on another residence.
As you can see, it is extremely important to understand these rules, but you do not have to make up your mind as to whether to take the once-in-a-lifetime exemption until your next tax return is due following the sale. Thus, if you sell your property in 1987, the decision need not be made until April 1988.
You should also be advised that the election to exclude up to $125,000 of gain may be used together with the tax-free rollover provisions, but you must discuss this with your tax adviser to make sure you are following the right procedures.
The question is always raised as to what happens if the prospective gain on the sale of a principal residence is substantially less than $125,000. Here, the taxpayer faces a major dilemma. If he or she elects to exclude the gain, the right to exclude the gain on the sale of a future home is lost forever -- even though a future sale may produce more gain. Unfortunately, there is no carryover of the unused portion of the exclusion. On the other hand, if the taxpayer opts to pay tax on the gain now, there's no guarantee that there will be gain on the sale of a future home, and again the once-in-a-lifetime exemption may be lost.
There's no easy answer. In large part, the right choice depends on the taxpayer's future housing plans, the amount of the gain and whether the present gain can be avoided by using the rollover rules -- thereby preserving the once-in-a-lifetime exclusion for future use.
In your case, you might want to consider amending your earlier tax return and opting for the once-in-a-lifetime exemption. But check this first with your tax adviser.
One thoughtful reader sent me a letter suggesting that Congress should recognize that the money that the senior citizen has made on the appreciation of the house should not be considered profit, but rather as inflation. Thus, Congress should not tax any of this gain. This is highlighted even more when one realizes that after selling your house, on which you have made a considerable profit, if you decide to buy another house, you probably will have to pay at least the same amount, if not more, and you may or may not have the same qualities as your older house.
Congress does not appear to be in the mood to expand tax benefits for homeowners. However, Congress should consider the concept carefully, with a view toward eliminating all tax on any appreciation of a personal residence, rather than merely limiting the exclusion to $125,000. Benny L. Kass is a Washington attorney. 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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.