The Mortgage Guru

One of the reasons real estate has gained popularity as a private investment is the capital gains tax advantage it offers over other investment choices. Individual home sellers can exclude the first $250,000 in profits from taxes; married couples filing jointly can exclude $500,000. With stocks and bonds, all long-term gains are now taxed at 15 percent.
Your capital gain on the sale of your home is the selling price minus your cost basis. The cost basis is your purchase price, plus qualified purchase costs, improvements and selling costs, minus any accumulated depreciation, say for a home-based business. A professional can help you more specifically calculate your gain if you are not sure what qualifies and what doesn’t.
To qualify, a taxpayer must have owned the house for at least two years and used it as a principal residence for two out of five years before the time it was sold. The two years don’t need to be consecutive.
When a taxpayer owns more than one residential property, determining whether a house qualifies as a principal residence requires looking at how the property is used, as well as other circumstances, such as the owners’ place of employment and where they receive their bills. If a taxpayer alternates residence between two or more homes, the principal residence is ordinarily the one at which the taxpayer spends the majority of the year. Tax laws also allow a taxpayer to take the capital gains exclusion each time the two eligibility tests are met. A taxpayer could theoretically sell a principal residence once every two years—indefinitely—each time walking away with a tax-free gain.

If, however, through some qualifying unforeseen event, such as a job change, illness or some other hardship, you are forced to sell before you meet the two-year residency requirement you can only prorate the $500,000 or $250,000 exclusion (not your specific gain) if you are forced to sell early. That means if you only live in your home one year — half the required time to get the full exclusion — and you are forced to sell for some qualifying unforeseen event, you can exclude from taxes, up to $250,000 in capital gains if you are married and file jointly or up to $125,000 for separate and single filers — half the total exclusion allowed.

What are unforeseen circumstances?

• Multiple births resulting from the same pregnancy.

• The death of the homeowner, a spouse, co-owner or other person whose principal place of residence is the house that was sold.

• Divorce or legal separation.

• Health problems, if the primary reason for the sale is “to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury” of the home owner, co-owner, spouse or other resident.

• A loss of employment triggering eligibility for unemployment compensation.

• A change in employment status that results in the owner’s inability to pay housing costs and reasonable basic living expenses.

• The “involuntary conversion” of your home, say, when the state government or other eminent domain order requires you to sell your house to make way for a new highway.

• Military duty. Military personnel posted abroad for extended periods can stop the clock on the two-of-the-past-five-years provision until they return stateside.

The Downside to High Prices

Unfortunately, the $250,000/$500,000 exclusion, which was a significant amount of money at the time it was enacted as part of the Taxpayer Relief Act of 1997, wasn’t indexed for inflation. Since then, home prices in the United States have increased significantly. Many taxpayers who have owned their home for years or reside in high-priced markets are shocked to learn they’ll face big capital gains tax bills when selling their home.

For example, in 1995 Mary and Bob Jones purchased a single-family home for $300,000 in Las Vegas and used it as their principal residence. Four years later, they sold the home for $900,000—a $600,000 gain. They then purchased a new home for $900,000.

Even though the Joneses used all their gain (and more) to buy a new home, only the first $500,000 was excluded for capital gains tax purposes. At a capital gains tax rate of 15 percent, the Joneses faced a $15,000 tax bill. The purchase of a replacement home in no way affects the tax consequences of the sale, though it did under previous tax law.

Lowering Capital Gains Tax Liability

There are strategies you can help sellers employ to mitigate their tax liability. Let’s begin by considering how capital gains are calculated. The capital gain on the sale of a home is defined as the amount realized on the sale minus the cost basis. The amount realized is the sales price minus selling costs. Selling costs include real estate commissions, legal fees, title and escrow fees, advertising, money spent to fix up the property just before sale, loan charges paid by the seller (such as loan placement fees or points), and real estate excise taxes. To calculate cost basis:

1. Start with the purchase price paid for the home.

2. Add these adjustments:
Costs associated with the original purchase of the property. These include abstract fees, recording fees, survey fees, title and escrow fees, attorney fees, real estate taxes owed, and inspection costs—but not points.
Costs associated with major improvements to the property. Major improvements are those that add to the value of your home, prolong its useful life, or adapt it to new uses. Finishing an unfinished basement, putting in new plumbing or wiring, or putting on a new roof would qualify. An addition, such as a deck, a sunroom, or a garage, is also an improvement. This category doesn’t include the cost of routine maintenance or repairs.

3. Subtract decreases, such as
The gain postponed from the sale of a previous home (before May 7, 1997). - Deductible casualty losses, such as those caused by natural disasters.
Depreciation allowed or allowable if the home was used for business or rental purposes.

The resulting amount is the adjusted cost basis. Subtract the adjusted cost basis from the adjusted selling price (selling price minus selling expenses) to arrive at total capital gains.

Home owners should keep careful records to prove a home’s adjusted cost basis for tax purposes. Information to keep could include proof of purchase price and purchase expenses, receipts for improvements that affect the home’s basis, and any work sheets used to calculate the adjusted basis of a previous home that was sold.

The favorable treatment of capital gains can be a good reason to invest in real estate. It can also be a motivation to sell and move on before the gain exceeds the allowable deduction. Whatever they do, however, your clients should seek the advice of a tax adviser before making any tax-related decisions about their home.

**Always seek the advice of a tax professional regarding your individual situation.

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