Tax Implications Of Selling Your Home

By: Tom Herman: The Wall Street Journal Online
Who can take advantage of the capital-gains-tax exclusion on home sales and when to get expert help.

While the Internal Revenue Service and Congress have declared war on tax shelters, nobody is threatening to touch America's most popular shelter: home, sweet home.

Tax laws long have offered favorable treatment to homeowners. But that treatment became even more favorable because of a 1997 tax law and Treasury Department regulations interpreting that law. As a result of those changes, millions of people who sell their primary residence don't owe a penny in capital-gains taxes.

The changes add up to an "extraordinarily generous tax break," says Bob Trinz, senior tax analyst at RIA, a New York-based tax information and software company and a unit of Thomson Corp.

Linda Goold, tax counsel at the National Association of Realtors in Washington, calls it "the most taxpayer-friendly provision I've seen during my career, which is almost 30 years now."

Surging home prices in recent years have made these rules even more important for growing numbers of homeowners, says Rob Hanson, a partner at Ernst & Young in Washington and a former Treasury tax legislative counsel who helped write the regulations. The national median existing-home price for all housing types was $206,000 in April, up 15% from $179,000 in April 2004, according to the National Association of Realtors.

But not everyone benefits from the 1997 tax-law changes. In some cases, homeowners may even have to pay more in capital-gains taxes than they did under the old regime.

Here is a primer on the rules and the latest regulations, who wins and who loses, and advice from tax lawyers, accountants and advisers on how to take advantage of the changes.

THE BASICS

The general rule of thumb is that if you sell your primary residence, you typically can exclude a gain of as much as $500,000 if you're married and filing a joint return with your spouse (or $250,000 if you're single or married filing separately) and meet certain conditions.

To be eligible for the full exclusion, you typically must have owned the home -- and lived in it as your principal residence -- for at least two of the five years prior to the sale. These exclusion amounts aren't indexed for inflation. (When calculating your cost basis, don't forget to include additions and other "improvements," such as a new roof, deck or heating system. However, this subject -- and other adjustments you may need to make -- can be tricky. For details, see IRS Publication 523.)

Real-estate agents say there is considerable confusion about the exclusion. Some people, for example, think this is a once-in-a-lifetime offer. It isn't. Homeowners can take advantage of the full exclusion every two years.

Some people also think the $500,000 exclusion is for everyone. It isn't. It's only for married couples filing jointly. Another point to bear in mind: This break applies only to your primary residence, not vacation homes.

Here's an example: Suppose you're married and file jointly. You bought your first home in the mid-1990s, have lived in it ever since, and your cost basis is $100,000. This year, you sell it for $600,000, giving you a $500,000 profit. Because of the 1997 law, you typically wouldn't owe any capital-gains taxes to Uncle Sam because your profit didn't exceed the maximum exclusion of $500,000.

What if you make a profit of more than the exclusion? If you sell your home this year for, say, $1.1 million, you wouldn't owe any capital-gains tax on $500,000 of your $1 million gain -- but the other $500,000 would be included in your taxable income.

Even if you have to sell your home in less than two years, you may be able to avoid Uncle Sam's grasp. The law allows a reduced maximum exclusion if the sale occurred because of a change in your place of employment, health reasons or "unforeseen circumstances."

Let's assume you're married and file a joint return, and you move from New York to California to take a new job. And so you have to sell your home after having owned it and lived in it for only one year. In that case, you typically would qualify for half of the maximum exclusion of $500,000, which means as much as $250,000 of your home-sale profit could be tax-free.

And what are "unforeseen circumstances"? Congress didn't define them in the 1997 law. But Treasury officials later issued detailed regulations offering numerous examples. Among them: divorce or a legal separation, multiple births from the same pregnancy, or the loss of your job. You may even qualify for a reduced exclusion if you or your spouse changes jobs and takes a pay cut that results in an inability to pay housing costs and reasonable basic living expenses.

WHO WINS -- AND LOSES

Most homeowners who sell are likely to benefit handsomely from the 1997 rules. But some people got hurt by the changes. That's because when Congress changed the law, it erased an old law often referred to as the "rollover" provision.

That provision generally allowed homeowners to defer the capital-gains tax on their gain if they sold their home and bought a new one that cost as much as, or more than, they got for the old one. The change simplified life for most home sellers and also greatly helped those who wanted to downsize. But it could hurt some people in real-estate markets where prices have risen especially rapidly and where owners have built up very large gains. Some of those people now would owe capital-gains taxes that they could have deferred under the old law by buying another residence.

Suppose you are single, sell your home for $500,000, netting a gain of $400,000, and buy a new home right away for $600,000. Under the old law, you could defer the capital-gains tax because you had rolled over your proceeds into the new home. Now, however, you would owe capital-gains tax on $150,000, the amount above the maximum $250,000 exclusion for a single person.

The 1997 law also replaced an old law that allowed a once-in-a-lifetime exclusion of as much as $125,000 for someone age 55 or older.

Ken Kies, a former chief of staff of Congress's Joint Committee on Taxation, recalls getting peppered with questions in 1997 from concerned tax lawyers in New York City. Those lawyers didn't think the exclusion amount was large enough for people living in hot real-estate markets such as New York City or Los Angeles.

"They suggested the exclusion should be bigger if you were in places in the country like New York or Los Angeles than if you were in less-active real-estate markets like Des Moines, Iowa," says Mr. Kies, now managing director of Clark Consulting's Federal Policy Group in Washington. "They were saying $500,000 wasn't enough for them. I told them I felt their pain but I didn't think anyone else would."

Some tax-policy wonks think the exclusions should be indexed to reflect inflation. But that hasn't happened yet and isn't likely to anytime soon, given growing congressional concerns about huge budget deficits.

MAKING THE MOST OF IT

Because home prices have surged in so many places, more homeowners may be bumping against the exclusion, or may even have bigger gains. What to do?

Some homeowners with king-size gains should consider holding onto the home and leaving it to their heirs, says Mr. Trinz. Under current law, all built-up capital gains typically disappear when the owner dies. The cost basis of the home to the heirs generally will be its fair-market value as of the person's date of death, not what he or she originally paid for it.

Another idea: Suppose you have a gain that's larger than the exclusion and you're thinking about selling your home this year. Consider also selling stocks or other capital assets that have tumbled in value, says Martin Nissenbaum, national director of personal income-tax planning at Ernst & Young in New York. Those losses can then be used to offset some or all of the gain on the sale of your home, which would otherwise be taxable, he says. "You can also use any capital-loss carryovers for that purpose."

First, capital losses can be deducted against capital gains. Second, if the taxpayer's losses exceed the gains, that person can deduct up to $3,000 ($1,500 if married and filing separately) of net losses each year against wages and other ordinary income. Excess losses are carried over to future years.

P.S. You can't deduct the loss on the sale of your primary residence.

WHEN TO GET HELP

Part of knowing how to take full advantage of tax laws involves knowing when to give up trying to understand them and seek professional help.

Who needs help? Mr. Trinz of RIA says the rules can get especially complicated if you marry someone who has recently used the exclusion, if the home is part of a divorce settlement, if you inherit the home from your spouse, sell a remainder interest in the home or took depreciation deductions on the home.

Also, questions have been raised about how to define your "principal" residence. The short answer is that it's typically where you spend a majority of your time during the year, but the issue can be considerably more complex.

For further information about this and other nuances, check out the IRS Web site (www.irs.gov) and search for Publication 523, "Selling Your Home." For the do-it-yourself crowd, RIA (ria.thomson.com/homesale) sells a publication called "Making the Most of the Home-Sale Exclusion."

There also may be tricky state-tax considerations, so check with your state tax department. An easy way to get general details is to check out the Web site of the Federation of Tax Administrators (www.taxadmin.org) and click on "Links."