The Best Tax Breaks Today
Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate
If I were to ask what's the best tax break available today you would probably think, since this is a real estate related newsletter, "it must have something to do with home-ownership", eh? Well, you would be correct! The best tax break does in fact come when you sell your home. And for the vast majority of you, you won't owe the Internal Revenue Service a single dime.
If you are a faithful reader of my newsletter, you have read on occasion about the IRC 121 exemption
which permits you to make up to $250,000 in profit if you're a single owner, twice that if you're married, and not owe any capital gains taxes upon the sale of your principal residence. Well, this month, I thought that I would provide you with a few ideas... all designed to save you some $$$.
Yes, most people are not going to have a tax obligation unless their gain on the sale of their home is huge and would you believe that some sellers are surprised by this break, especially if they've been in their homes for a while. That's because before May 7, 1997, the only way you could avoid paying taxes on your home sale profit was to use the money to buy another, more-expensive house within two years. Sellers age 55 or older had one other option. They could take a once-in-a-lifetime tax exemption of up to $125,000 in profits. And in all instances, there was tax paperwork to fill out to show that you followed the rules. But when the Taxpayer Relief Act of 1997 became law, the rollover and once-in-a-lifetime options were replaced with the current per-sale exclusion amounts. Besides the basic $250K/$500K exclusion amounts here are some of the additional nuances:
- You don't have to buy another home with your sale proceeds. You can use the money to travel to Europe in style, buy an RV or get all those designer shoes you never could afford before.
- Even better, there's no limit to the number of times you can use the home sale exemption. In most cases, you can make tax-free profits every time you sell a home.
- The property you're selling must be your principal residence. That means you live in it. This tax break doesn't apply to a house or other property that you have held for investment purposes. In those cases, the usual federal & state capital gains rules apply.
- You can turn a rental house into your primary residence, making the sale of it eligible for the exclusion. This is accomplished when you meet the IRS use and ownership tests meaning that you own and live in the home for two out of the five years before the sale. A bit more about this strategy later.
- Your actual habitation of the home doesn't have to be sequential. The IRS lets you aggregate the time you live in the house in order to meet the two year residency requirement. Generally, if you owned and used the home as your main home for periods totaling at least two years within five years ending on the date of the sale, you will be eligible for the exclusion.
- You do not have to be living in the house on the date of sale. The flexibility of the use test means you could live in your house for a year, rent it for two, move back in for another year and rent it again the year before you sell. Since during those five years, you owned and lived in the property for two years, you meet the use and ownership tests.
- While technically there's no limit on the number of homes you can sell and reap tax free gains, each sale must be at least two years apart. That still leaves you room to make some money on several properties. You can sell your residence this year, pocket any gain within the tax limits and buy a new residence. Two years later, you can do the same thing again. And3; again in two more years.
- If you are an owner of multiple properties, you might consider doubling-up on the tax free gain. As an example, let´s say you sell your primary residence and then establish your vacation home as your primary home for a couple of years and then sell that home. Empty-nesters who have a large suburban home could move into their "vacation" home here in Pacific Beach and then as they get older, move to a residential facility or in with the kids (hey, I've already prepped my son!). Then, you can sell both homes and not have any taxable gains.
Note: Be careful tho if you plan to move into a rental property you acquired through a like-kind, IRC 1031 exchange
as there is a tougher test. If the property you convert to your principal residence is one that you earlier obtained via an "exchange", in order to take advantage of the home sale exclusion, you must have acquired the property at least five years earlier.
- The pesky reporting requirements of the past are history. When your gain doesn't exceed the limit, you don't have to file anything with the IRS.
- While a husband and wife get double the exclusion of single home sellers, couples may have some additional considerations when it comes to determining whether their sale is entirely tax free. For instance, either of the spouses can meet the ownership test because the IRS says it's OK if you owned the home for the last two years, but let´s say you just added your new husband to the title when you got married six months ago. Since one of you owned the residence for the requisite time, as joint filers you have no problem meeting the ownership test even though your husband wasn't an official owner for that long. However, both spouses must pass the use test. That is, each must live in the residence for two years. So, if you and your new husband shared the home for 1½ years before tying the knot and then six months as newlyweds, the IRS will allow you to claim the exemption. But, if he didn't move in until the wedding day, you're out of tax-exclusion luck.
- The two year eligibility rule does apply to both spouses. Thus, if either spouse sold a home and used the exclusion within two years of the sale of any jointly owned property, the couple can't claim the exclusion. That means if your new husband sold his townhouse a month before the wedding, then you'll have to wait two years after that property's sale date before you can dispose of your shared marital residence tax free.
- One can also combine the principal residence exemption (IRC 121) with a "like-kind" tax deferred exchange (IRC 1031) on the same transaction. Suppose a couple lives in one unit in a multi-family building and uses section 1031 to exchange the portion of the property in which the couple does not reside. Thus, the unit they reside in is sheltered up to a $500K gain and the remainder of the building is exchanged as an investment property under section 1031.
Calculating Your Gain
OK, so you have successfully met both the use and ownership tests, as well as the two-year previous sale time limit. Now it's time to do the math to avoid writing a big check to the U.S. Treasury and if you live in California, to the Franchise Tax Board.
As a seller, you naturally focus on the sale price of the home you just sold. That is an important number, but not the only one you'll need when it comes to figuring out whether you'll owe taxes on the sale. It's really your gain, or profit, that determines the size or lack of a tax bill. In fact, you can sell your house for $1 million and still not owe Uncle Sam as long as the profit portion was not more than $250,000 or $500,000, depending on your filing status. If you can exclude all the gain, then you owe no taxes.
To arrive at your gain amount, you first must establish your cost basis in the home. For most people, this is what you paid for the residence plus any closing costs on the purchase which have not already been deducted, and all capital improvements you've made, such as adding a room or adding a deck. Also, if you sold a residence prior to the 1997 law change and rolled the profit into the home you're now selling, you must account for that rollover amount; your basis will decrease by the amount of gain you postponed years ago.
Then, you compare the cost basis amount to what you realized from the sale, less your commissions and other expenses. Subtracting your cost basis in the residence from the adjusted sale amount will give you the amount of your gain on the sale.
In most instances, sellers will find they made a nice profit, but not one large enough to trigger a tax bill. Some, however, could find their residences appreciated so much over the last several years that they could get nicked a tad. This is why it is vitally important to accurately keep track of anything that could affect your home basis
. Yes, there is a lot of talk about how you no longer have to keep records of home capital improvements, but the way the home prices have escalated, you probably need to be safe and maintain such records. The improvements increase your basis so a smaller portion of the selling price would be viewed as a gain. Any overage is taxed at the current long term capital gains rate of 15% federal and because California does not have a separate capital gains rate, that´ll be 9.3% to the Governor, please.
Even if you do not meet all of the home sale exclusion tests, your tax break might not be totally lost.
When an owner sells his house because of "special conditions
", such as a change in health, employment or unforeseen circumstances, he's eligible for a prorated tax free gain. In such a case, you first calculate the fractional amount of time that you met the two year use test. For example, a single homeowner is transferred to a job in another city and sells after being in his home for only a year and a half. He would have an occupancy period of 18/24 (the number of months he lived in the home divided by 24, the number of months in the two year occupancy requirement) or 0.75. By multiplying the full $250,000 exclusion amount by 0.75, the seller would be eligible to exclude a sale gain of up to $187,500.
Members of the military also get "special home sale
" consideration. Because of re-deployments, military personnel often find it hard to meet the residency rule and end up owing taxes when they sell. But a law change in 2003 now exempts military personnel from the two year use requirement (for up to 10 years), letting them qualify for the full exclusion whenever they must move to fulfill service commitments.
So, what´s the bottom line? Well, I would say that the vast majority of you should quit worrying about taxes when you put your home on the market. Chances are good that both Uncle Sam and Uncle Arnold won't be able to lay any claim to your hefty home sale profit and that´s a very good thing.