When Congress passed the Taxpayer Relief Act of 1997, the Washington real estate market was still in a recession. No one at that time could imagine the boom we had last year.
But this year home sellers will begin to see the fruits of that law when they prepare and file their 1999 income tax returns. For years, there were two tax concepts that often saved homeowners a lot of grief and a lot of capital gains tax: the "rollover" and the "once-in-
The 1997 tax law abolished both of these concepts for sales that took place after May 6, 1997. For all practical purposes, the rollover and the once-in-a-lifetime exemption are real estate and tax history.
Now there is a simpler and more liberal approach to calculating gain on the profit you have made as a homeowner.
For sales of a principal residence after May 6, 1997, married couples can exclude from their taxable income up to $500,000 of gain. Individuals filing separate returns can exclude up to $250,000.
There are no restrictions on the number of times this exclusion can be used, compared with the old once-in-a-lifetime approach. There are two important limitations:
* 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, so long as either spouse meets this requirement, the exclusion of gain applies. Marital status is determined on the date the house is sold. In the event of a divorce where 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 (as defined in Internal Revenue Service regulations), then your exclusion is pro-rated. This pro-rating is complex and has caused considerable confusion among lawyers, taxpayers and even the IRS. Most homeowners who are required to sell their home within less than two years probably will not be fortunate enough to have made sufficient profit to be concerned about this issue.
The law applies to all principal residences: single-family homes, cooperative apartments and condominium units. If your boat or your mobile home is your principal residence, the law also applies. In order to qualify as a principal residence, three things are required: sleeping quarters, a toilet and cooking facilities.
The old rollover rules were mandatory. If your situation met the requirements, you had to take the rollover. Under the new law, however, homeowners can opt not to use the new exclusion laws and just pay the normal capital gains rate. For taxpayers who have made a large profit on the sale of their home but are in a low tax bracket, this may be to their benefit. Obviously, you have to confirm this with a tax adviser.
Although the new $250,000 and $500,000 exclusions sound too good to be true, there is one important fact to remember when calculating the profit you have made and the tax you may have to pay: You could have a larger gain than you first think.
Real estate in the Washington area appreciated dramatically in the 1960s, 1970s and most of the 1980s. Many homeowners realized the "great American dream" over the years and continued to sell and "trade up" to more expensive houses. The profit made on each sale was deferred under the old rollover concept. The profit you made and deferred in the past may affect what you owe when you sell.
Look at this example: In 1967, you bought your first house for $35,000. In 1976, you sold it for $150,000 and bought a new house for $215,000. (For purposes of our example, we will ignore such items as home improvements and real estate commissions, although these are expenses that should be taken into consideration in determining profit.) Because you deferred $115,000 of profit ($150,000 minus $35,000), the basis in your new home is now $100,000. You determine your basis by subtracting the profit from the purchase price (that is, $215,000 minus $115,000).
In 1988, you sold your home for $420,000 and bought a new house for $490,000. Because the rollover was still law, you deferred profit of $320,000 ($420,000 minus $100,000). The tax basis of the $490,000 home is $170,000. You may question the $100,000 number that we are using as your basis, because you bought your second house for $215,000. Because the basis of that house was $100,000, profit is computed by subtracting the basis of the house (and not just its purchase price) from the sales price.
Here is where the tax bite may occur. If, for example, you plan to sell your house in the near future, you must be aware of your basis. If you are married, 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 the house for more than $670,000.
But if your spouse has died and you are now filing a single tax return, you can shelter only up to $250,000 of profit. Thus, even if you sell the house for what you paid for it--$490,000--you will have made a profit in our example of $320,000 and will have to pay capital gains tax on $70,000 worth of profit (i.e., the excess over $250,000). The capital gains tax rate is 20 percent, so the federal tax will be $14,000.
Clearly, for many older Americans, especially when one spouse has died, this is unfair. Thus, it is critical that you keep all your records and settlement sheets. Such expenses as home improvements and real estate commissions plus legal and title costs will reduce your basis and thus reduce your tax. If you are ever audited by the IRS, you will be required to produce proof of these expenses.
If you sold your principal residence in 1999, you no longer have to report the sale on Form 2119. Such sales are now reported on Schedule D of Form 1040 but only if you have to pay capital gains tax, i.e., your profit is more than $250,000 or $500,000.
Next: New home-office deduction rules
Kass is a Washington lawyer. 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.