LEAVE IT TO Congress to take
a simple idea -- no more tax bills on the profit you make when you sell your
home -- and make a mess of it. But that’s what has happened with the rules
governing home sales. The more government has thought about them, the more
confusing the rules have become. First, the rule itself: If you’ve owned your home and have lived in it
for two of the previous five years, then you can make a profit of up to
$250,000 if you’re single or $500,000 if you’re married, with no tax
bill. This deal is so good that you should do everything you possibly can to
get it.
At first glance, these exclusions seem pretty high. Who really makes a
profit of a half a million dollars on a house? Maybe you. A Silicon Valley
house bought 25 years ago for $100,000 could easily be worth more than a
million bucks today. Of course, not everyone lives in the nation’s most
insane real estate market, but there are other markets almost as hot,
including San Diego, where prices rose almost 11% last year, and even
Kalamazoo, Mich., where the jump was 13%.
More likely, though, you will top the limit because your gain must include
all the profit you’ve made on any previous houses you’ve owned. Why?
Because the old rules allowed people to roll over their gains into a bigger
house without paying taxes, and that’s what most people did.
So when you calculate your gain under the new rules, you have to include
the gains you rolled over into your current house. Say you’ve owned three
homes over the past 20 years, and each one appreciated by $100,000 in the
time you owned it. You probably rolled the profits from each home into the
next, meaning you have $300,000 in accumulated gains. If you’re single,
that means you’re going to have to pay taxes at the long-term capital gains
rate (most likely 20%) on $50,000 of that profit. If you’re married,
though, you’re safe.
Still confused? IRS Publication 523, available on the IRS Web
site, has worksheets for calculating the cost of your house for tax
purposes -- including increases from improvements -- and the exact amount of
your gain. If you’ve rolled over your prior gains, you’ll need to dig up
the tax return for the year of the last sale. In there, you should find Form
2119 (Sale of Your Home), which lists the cost basis of your current home,
taking into account any gains rolled over from previous residences. You take
that amount and add the cost of subsequent improvements to arrive at the
final cost basis for your home. Check out these publications
from the IRS for the tax year 1999. These publications are formatted in
Adobe PDF format and require Adobe Reader 3.0 or higher. If you don't
have Adobe Reader, click on the Adobe icon below.
What all this means is that you can’t, as everyone was hoping, just sell
your house and pocket the cash. You’ve got to know the rules first, or you
could become the horrified new owner of a six-figure tax bill.
| 1999 IRS Publication 523 - Selling your Home |
| Correction to Publication 523 (Selling Your Home) |
Do You Qualify?
Once you've got the dollars straight, you’ve got to make sure you actually
qualify for the tax break. If you’ve owned your home and have used it as
your principal residence for two of the past five years, you’re home free.
No taxes up to the limit, and no questions asked. (Be careful of the "antirecycling"
rule, which limits you to one exclusion every two years.)
What if you don’t meet these qualifications? In some cases you can get partial credit, provided you meet some specific criteria. That means if you lived in the house for a year, you would get half of the exclusion, or $125,000 for individuals and $250,000 for couples.
Here are two loopholes that will get you the partial credit. First, if you owned your house on Aug. 5, 1997, and sell it before Aug. 5 of 1999, you get the partial tax break automatically. This is sort of a grace period between the new law and the old. So if you’ve been renting out your house for the past four years and are considering selling it, you might want to get the deal done before this August. Then, at least, you’ll get half of the tax break. This loophole won’t help you with the antirecycling rule, though.
The second loophole applies if you bought your home after Aug. 5, 1997, or sold it after Aug. 4, 1998. The rule says that if you don’t meet the two-out-of-five-year criterion, you can still get a partial tax break if you had to move for health reasons or for a change in job location.
The rule works like this: Say you moved your family to a new town six months ago, just before Disney decided to build its next theme park down the road. Now your boss decides to transfer you. So you sell your house and make $100,000 on it. Since you’ve lived there for one-fourth of the two-year period required for a $500,000 gain exclusion, your maximum tax break would be $125,000, leaving you in the clear. This loophole is the only way to circumvent the antirecycling rule.
The Depreciation Dilemma
If you've rented your home or had a home office, things get a lot more
complicated. In both cases, you would have taken a depreciation deduction for
all or part of your home. Now you’re going to have to pay the tax you’ve
been deferring through the depreciation deduction since May 6, 1997, when the
law took effect.
Here’s how it works. Say you used 25% of your home as a deductible home office the entire time you lived in the house, and you sell the house for a $100,000 profit. You’ll have to pay tax on the portion of your profit that came from the office, or $25,000. And since you’ve deducted the home office, that also means you’ve taken a depreciation deduction each year, which in this case totals, say, $5,000. That adds to your gain. The $25,000 profit will be taxed at the maximum 20% rate for long-term capital gains, and the $5,000 will be taxed at a special 25% rate under a specific rule for "unrecaptured Section 1250 gains." Your total tax bill: $6,250.
Don’t want to write that check? We don’t blame you. Here’s our advice: If you know you’ll be moving soon, give up the home-office deduction for two years. Then that portion of the house meets the two-out-of-five rule, and all of your profit will be tax-free, except the amount you deducted for depreciation after May 6, 1997.
Death and Taxes
When death, marriage or divorce is the reason for the sale, the new rules
force you to act fast or smart or both. It’s the two-out-of-five-year
requirement again.
If a spouse dies, the survivor can file a joint return for that year, meaning you’re safe if the profit is $500,000 or less. After that year, your exclusion drops to $250,000, meaning that if you have a house with a big gain or have accumulated a big gain from a lifetime of home ownership, the time to sell is now. Keep in mind that if you inherit your spouse’s portion of your home, his or her tax liability is wiped away, so your gain may not be as big as you think.
Divorce is also tricky under the new rules. If you sell the house before the divorce, you get the $500,000 exemption as long as you file a joint return. But if one spouse takes ownership after the divorce, the limit falls to $250,000.
In one common scenario, the two former spouses both continue to own their home. In this case, the nonresident will eventually fail to meet the two-out-of-five-year rule. When the house is sold, only the resident spouse gets the $250,000 exclusion. One way to avoid this trap is to have your divorce papers specify that one ex-spouse can continue to live in the home, for example, until the children reach a certain age or for a set number of years. Making this arrangement a written condition of the divorce allows the spouse who moved out to get credit for living in the house, keeping his or her gain exclusion.
On a brighter note, if both members of a newly married couple own their own homes, they each get a $250,000 break, even though they will be filing jointly. But if one spouse has a huge gain on a house, it might pay for both of you to live there for at least two years before selling. And if the sale is more than two years after the sale of the first home, then you’ll get the full $500,000 tax break. Not a bad way to start off a marriage.