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Avoid A Capital Gains Tax Bite

A former neighbor, John, still wonderfully engaging at 91, has been living in an assisted-living community for nearly three years. He stops by his former primary residence periodically and has dinner with folks in the area about once a week.

His wife, Irene, passed away more than a decade ago and we can still visualize her walking to her tiny studio behind the house.

John and Irene have owned the home for more than 40 years and their three adult children have grown and moved away. While it had been rumored one of them might move in and call it home, various events altered that possibility and the place has sat vacant for most of the past three years.

Recently, John’s financial counselor mentioned to the children that a decision needed to be made — quickly — in order for John to avoid a capital gains tax on the family home. The suggestion caught the children completely off guard because the home needs a significant amount of deferred maintenance to make it appealing to a potential buyer, especially in a soft market.

In order to qualify for the $500,000 capital gains exclusion ($250,000 for single persons), you must have owned and used the property as your principal residence for two out of five years prior to the date of sale. You must not have used this same exclusion in the two-year period prior to the sale. The only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.

Many taxpayers, including seniors who have already used the one-time “over 55” exclusion of $125,000, do not realize they are eligible to sell their primary home again — and do it every two years — under the Taxpayer Relief Act of 1997. The 1997 law repealed all former tax laws on primary residences and significantly changed the role of the home in regard to financial planning.

What is often misunderstood is both the earlier one-time exclusion of up to $125,000 in gain for persons over 55, and the ability to defer all or part of a gain by purchasing a qualifying replacement residence have been replaced by the 1997 law. You no longer can utilize parts of the old law, and you absolutely do not have to buy a replacement home.

Persons who used the $125,000 can make use of the new exclusion if they meet the two-year residency test. The law enables seniors to “buy down” to less expensive homes without tax penalties.

For gains greater than the exemption amounts, a 15 percent capital gains tax usually will apply. If your profits are less than the exemption amounts, you probably will not have to keep tax records and account for the profits at tax time.

Homeowners with potential gains larger than the excludable amounts should keep accurate records in an attempt to reduce their gains by the amount of all eligible improvements.

For married taxpayers who file a joint return, only one spouse need meet the two-out-of-five-year ownership requirement, but both spouses must meet the two-out-of-five-year use requirement.

That is, if the husband has owned and used the house as his principal residence for two of the past five years, but his wife did not use the house as her principal residence for the required two years, then the exclusion is only $250,000. This would apply to John.

For those who leave their home because of a disability, a special rule makes it easier to meet the two-year requirement, especially if you were hospitalized or had to spend a significant period in a similar facility.

In such cases, if you owned and used the home as a principal residence for at least one of the five years preceding the sale, then you are treated as having used it as your principal residence while you are in a facility that is licensed to care for people in your condition. This rule enables the family to sell the home to raise cash for the expenses without incurring a large tax consequence.

If you, or your folks, have moved out of the family home, make sure everyone involved is aware of the time frame for capital gains taxes. The bite could be surprising.