The taxation rules relating to selling a home are fairly simple. Be it your primary home or an investment property, the amount subject to taxation isn’t too difficult to figure out, as long as you have kept good records during the time you have owned the property. But we continually get questions about how the sale of a home might be taxed, and one of the main reasons for the confusion is due to the fact that the rules were changed significantly due to the enactment of the Taxpayer Relief Act of 1997. In this article, we will discuss the rules prior to 1997, and the rules as they stand now, to clarify how things have changed and how current homeowners can determine their potential tax liabilities for selling a home. And since the rules for state taxation generally conform to the IRA rules, at least in California, for the purposes of this article, we will focus only on the rules for federal taxation.
Please note that we are not tax professionals, and all tax matters should be discussed and confirmed with a qualified tax professional before making any decisions.
Prior to 1997, Deferred Gain on Sale of Home, also known as the ‘Rollover Rule’ was a tax law allowing homeowners to defer recognition of capital gains from the sale of a principal residence. Proceeds from the sale had to be used within two years to purchase a new principal residence of equal or greater value. This ‘Rollover Rule’ also included the ‘Over 55 Home Sale Exemption’ which allowed individuals who met the requirements to exclude up to $125,000 of capital gains on the sale of their personal residences.
Oddly, many taxpayers we speak to believe these rules, particularly the ‘Rollover Rule,’ are still in effect. Bad marketing by the federal government, perhaps? Whatever the reason, the bottom line is that with the passing of the Taxpayer Relief Act of 1997, the government repealed the Rollover Rule, and abolished the over-55 home-sale exemption, replacing it with the new ‘Home-Sale Gain Exclusion.’
Under the new rule, if you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.
In general, to qualify for the exclusion, you must meet both the ownership test and the use test. You’re eligible for the exclusion if you have owned and used your home as your main home for a period of at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.
The repeal of the ‘Rollover Rule’ and replacement of it by the ‘Home-Sale Gain Exclusion’ rule simplified and expanded the tax benefit, because unlike the old rule, the ‘Home-Sale Gain Exclusion’ does not make taxpayers buy a similarly priced, or more expensive replacement residence within a prescribed period. It does not make homeowner taxpayers who used the home for rental or business purposes to split the basis between the portion used as a principal residence and the part used for rental or business purposes. It does more than merely defer recognition of gain with a timely rollover. It permanently eliminates the tax on gains realized up to $500,000 for married taxpayers and $250,000 for unmarried ones.
The downside, of course, is that under the old rule, homeowners could defer capital gains taxes continually during their lifetimes, even if they moved from time-to-time. And if they never actually needed to sell their primary residence to use the assets, they could then pass on the home to the next generation. In many cases, due to the step up in cost basis at death, they could effectively avoid capital- gains taxes entirely.
For rental properties, the rules are slightly different, as there is obviously no exclusion available for capital gains on a primary residence, since most rentals will not satisfy the ownership or use tests needed to qualify. This means all capital gains on a rental property are subject to taxation. However, there is an exemption similar to the ‘Rollover Rule,’ which can potentially allow for deferral of some or all capital-gains taxes, available for rental-property sales, called a Section 1031 exchange. Section 1031 of the tax code allows property owners to sell a rental property while purchasing a similar property and pay taxes only after the exchange is made. Timing is key with this method, because investors have just 45 days from the date of a property sale to identify potential replacement properties, which they must formally close on within 180 days.
There are some other differences in taxation of rental properties, relating to amortization and certain deductions, which are beyond the scope of this article, so it is even more important to consult a tax professional when determining the ultimate tax treatment of rental properties.
One final note about cost basis. Since the calculation for determining whether or not you owe capital- gains tax on the sale of your home basically comes down to the proceeds of the sale minus your tax basis, determining your correct tax basis is vital for this purpose. Many believe that your cost basis is simply the price you paid for the home, but, in reality, there are a number of other factors which can affect your ‘adjusted cost basis.’ This is the number which is actually used to determine your gain. While there are some more obscure items, such as depreciation, tax credits for energy upgrades and insurance payments for loss or theft, which can reduce your basis, and some, like certain legal and recording fees that can increase it, the most common factor that will affect your adjusted cost basis is capital improvements made along the way. This is why it is so important to keep very good records of any improvements made while owning your home, so that your adjusted basis takes into account all of those expenditures.
We hope this article helps to clarify the tax treatment of the sale of a home, whether a primary residence or a rental property, so that homeowners can be fully informed on their potential tax liabilities and avoid the confusion that still exists with regard to the capital-gains tax rules currently in place.
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