Remember the old rollover? It provided a tax benefit for those of us who sold and then bought principal residences before 1997. That old friend is no longer with us. However, for many taxpayers who are now considering selling a home, its memory lingers on – and can haunt them financially.
The rollover was in force through May 6, 1997. The Taxpayer Relief Act of 1997, signed by President Bill Clinton, abolished the rollover. In its place, the 1997 law substituted a more liberal (and simplified) approach. For sales of a principal residence after May 6, 1997, married couples can exclude from their taxable income up to $500,000 of capital gain. Individuals filing separate returns can exclude up to $250,000.
The law has two important limitations:
You must have owned and used the home as your principal residence for two out of five years before the sale. If you are married, as long as one spouse meets the ownership and both meet the “use” requirement, the exclusion applies. Marital status is determined on the date the house is sold. In the event of a divorce in which one spouse is awarded sole ownership pursuant to a divorce decree or separation agreement, the use requirement will take into account any time that the other spouse had an interest in the property before that interest was transferred.
The exclusion is generally applicable once every two years. However, if you are unable to meet the two-year ownership and use requirements because of a change in employment, health reasons or unforeseen circumstances, then the exclusion is prorated.
These “prorations” are complex and require professional guidance. On the other hand, most homeowners who have to sell a home in less than two years will probably not have made enough profit to be concerned about this issue.
Although the new $250,000/$500,000 exclusions sound good, there is one important point to remember when calculating your profit. Real estate has appreciated dramatically over the years, and many homeowners pursued the “great American dream” by selling and “buying up” repeatedly. If your current house was purchased before the May 1997 “trigger date”and you decide to sell, you have the right to take advantage of the gain exclusion. But you have to look carefully at any previous home sales to determine the tax basis of your current home.
For example, let’s say that in 1965, you purchased a house for $50,000. Then, in 1975, you sold it for $150,000, and purchased a new house for $200,000. (For purposes of this example, we will ignore such matters as home improvements and real estate commissions, although such expenses can – and should – be taken into consideration in determining profit.) Because of the rollover, you deferred $100,000 of profit ($150,000 minus $50,000), and the basis of your new home became $100,000. You determine the basis by subtracting the reinvested profit from the purchase price.
In 198, you sold that second home for $400,000 and purchased another one for $500,000. Now, because of the rollover, you deferred profit of $300,000 ($400,000 minus $100,000), and the basis of your new, $500,000 home is now $200,000 ($500,000 minus $300,000). You may be tempted to question the use of $100,000 in computing the profit, because you purchased your second house for $200,000. But remember: The basis of that house was only $100,000, and the profit is computed by subtracting the basis of the house (and not its purchase price) from the sales price.
The problem starts when you decide to sell the house you bought in 1987. Now you will have to determine the house’s basis, and to do that, you will have to take into account your history of home buying and selling, which in our example goes all the way back to 1965.
In the example above, if you are married, file a joint tax return and have lived in the house for at least two out of the past five years, you will not have to pay any capital gains tax unless you sell the house for more than $700,000 (i.e. a basis of $200,000 plus the exclusion of $500,000.)
But the numbers in that example – for many homeowners – are very low. Houses that 10 years ago were selling for $300,000 to $400,000 are now bringing in more than a $1 million in many parts of the country. For a longtime serial home buyer, the capital gains exposure could be pretty scary.
That is why it is so important to keep all of your records, including all of your settlement sheets. Such expenses as home improvements, real estate commissions, fix-up costs, legal and title costs, will increase your basis – and lower your tax.
You must keep all of your records.