This tax season should prove much simpler and less taxing for most home sellers.
May 7, capital gains tax on the sale of a house became a thing of the past for virtually all homeowners.
The Taxpayer Relief Act of 1997 created a new tax exemption that will enable most married couples to permanently escape tax on the first $500,000 in profits from the sale of a principal residence. Other individuals are eligible for an exemption of up to $250,000. The exemption applies to homes sold on or after last May 7.
Despite the large exemption, there will be some people who sold a home since May 7 who will end up paying tax on their gains this tax season - in some cases, more tax than would have been due under the old law. Chief among them are homeowners who sold mansions or lived in places like Silicon Valley or Manhattan, where appreciation resulted in gains that exceeded the $250,000 or $500,000 exemption limits.
The new law could also prove more costly and complicated for those who sold a home that was used partly for business or rental purposes. In fact, the way the new law treats such sales might make many owners think twice about claiming home-office deductions.
Also likely to be disappointed are homeowners who sold their residence for less than they originally paid for it. Losses on the sale of a personal residence remain non-deductible. Although many in Congress supported proposals to make home-sale losses deductible as a capital loss, no such provision was included in the 1997 tax law.
Two-year requirement
As a general rule, you can claim the new home-sale exemption provided that you owned and used the home as your principal residence for at least two of the five years before the sale.
But even if you needed to sell before you met the two-year requirement, you'll probably still be able to escape tax on most or all of your home-sale profit.
A prorated exemption can be claimed if you sold your home before meeting the two-year requirement because of a job-related move, for health reasons or for other "unforeseen circumstances" that the IRS has yet to define in regulations.
What's more, there is special dispensation if you owned your home Aug. 5, 1997, and sell within two years of that date. No matter what your reason for selling before meeting the two-year residency requirement, you'll be eligible for a prorated exemption.
So if you sold a home after having owned it only six months because your company needed your talents in New York instead of Dallas, you'll be eligible for one-quarter of the normal exemption amounts - since your six-month stay fulfilled only one-quarter of the two-year residency requirement. That would provide you with a $125,000 exemption on a joint return or $62,500 on a single return.
Most people who sold a residence before May 7 won't have to pay a cent in tax this year on their gain, either. Although homes sold before May 7 aren't eligible for the new exemption, the old law's tax breaks should help most people who sold a home early last year to escape capital gains tax or at least defer it indefinitely into the future.
Under the old law, home sellers are eligible to defer tax on all profits from the sale of a principal residence as long as they buy a replacement residence within two years that costs at least as much as they realized from the sale of their old home.
The old law also provides a special one-time break for home sellers aged 55 and over: a permanent tax exemption for up to $125,000 in profits from the sale of a principal residence.
Window of choice
If you sold your home between May 7 and Aug. 5 last year, you generally have the option of having your home sale treated under either the new law or the old law. This option is also available to homeowners who sold after Aug. 5 pursuant to a binding contract in effect Aug. 5. You also have the option if you sold after Aug. 5 but bought a replacement residence on or before Aug. 5.
Of course, most homeowners will find the new law's tax exemption far superior to the old law's breaks. But some sellers who can't protect all of their profits from capital gains tax under the new law exemption might be tempted to stick with the old law treatment.
For example, if your home-sale profits exceed the new law's exemption limits, you'd be forced to pay immediate tax on your gain to the extent it exceeded the exemption amounts. But by taking advantage of the old law, you might not have to pay a cent in tax this year on your home-sale profits. You could indefinitely defer tax on your entire gain as long as you bought a replacement residence within two years that cost at least as much as the one you sold.
But before opting for the old law treatment, carefully assess the consequences for your next home sale.
"In general, it wouldn't make sense" to elect the old law treatment, said Mark Luscombe, a federal tax analyst for CCH Inc., a major legal publisher. The reason: The old law treatment will only defer tax on your gain until your next home sale. And by forgoing the new law exemption now, you're missing out an opportunity to have up to $500,000 of your gain exempt from tax. The exemption can be used as often as every two years.
If your gain exceeds the exemption limit, about the only situation where it might pay to use the deferral-option is if you expect to live in your replacement home for many years and expect little appreciation in its value, said John Gardner, a senior manager in the Washington, D.C., office of the accounting firm KPMG Peat Marwick. By using the deferral-option, you could avoid paying tax on your gains for many years, which would leave you with extra cash to profitably invest in the interim.
Home-office advantage
Deferral might also help some homeowners who claimed home-office deductions in prior years but didn't qualify for the write-offs in the year of the sale. In such cases, the old law allows tax on the entire gain to be deferred. Under the new law treatment, the portion of the home used for business might be subject to tax.
Indeed, many people who claimed deductions for a home office or rented out part of their home could end up paying tax on part of their home-sale profit - even if their gains were less than the new law's exemption amounts.
One reason is that the new exemption can't be used to protect the part of your gain that is equal to any depreciation deductions allowed for business or rental use of the property for periods after May 6, 1997.
In addition, unless 100 percent of your home qualified as a principal residence for at least two of the five years preceding the sale, you'll be forced to pay capital gains tax on the business portion of your home. If, say, your home office occupied 10 percent of your home, 10 percent of your home-sale profits wouldn't qualify for the new law exemption. The new exemption can be used only for the portion of your home used for personal purposes for at least two of the five years.
As a result, eligible homeowners should reassess whether it's really worth having a deductible home office - particularly in the two years prior to a sale, advises Thomas Beneventi, a Chicago area tax partner at the national accounting firm of McGladrey & Pullen. "I don't think it's worth it," he said. "It can really whipsaw you later."
Home-based workers needn't go so far as to move their operation to a commercial office building. Simple steps can be taken to make a home office ineligible for deductions, such as by making the office available after-hours to your children for homework and playing video games.
That will violate the home-office deduction requirement that the space be used exclusively for business.
