In mid-1997, the federal tax law changed to provide that a taxpayer may exclude from income up to $250,000 of gain on the sale of a personal residence. Under prior law, taxable gain could be rolled over into a new residence, with a corresponding basis adjustment, and there was also a “one-time” exclusion of $125,000 of taxable gain for taxpayers age 55 or older. The new rules are codified in Section 121 of the Internal Revenue Code.
Under the new rules, which actually exclude realized gain from taxable income (thus resulting in a tax free sale), the amount of excludable gain is doubled to $500,000 for married individuals filing jointly. Generally, the residence must be owned and occupied as a principal residence for at least two of the five years preceding the sale. The exclusion can be used more than once, provided it is not used more frequently that once every two years. Because of the strict ownership and occupancy requirements of the new law, there are special rules applicable to divorced taxpayers and certain taxpayers suffering unforeseen hardships which would otherwise prevent them from meeting the two year requirement. These hardships include forced changes in employment location, hardship caused by health problems and other unforeseen circumstances not caused by the taxpayer.
There is a corresponding provision under state law which now excludes gain from the sale of a residence from state income tax. Under prior law, subject to certain exceptions, gain on the sale of a home was subject to state income tax.
Because the impact of the new rules can result in substantial tax savings, the timing of a proposed sale can be critical. Assuming you are not forced by circumstance to sell your residence by a particular date, make certain to review the ownership and timing rules under these new provisions to make the most of this new opportunity.
Commentators on the new rules in this area have suggested that it is no longer necessary for homeowners to keep records of capital improvements which increase the basis of a residence (thus reducing taxable gain) on the theory that all of the gain will be excluded. However, we recommend that such records be kept if there is any possibility that a taxpayer might realize income on the sale. This can still occur in several circumstances, including where the residence appreciates rapidly, potentially exceeding the $500,000 exclusion, as well as the circumstance where the owner does not use or own the residence long enough to qualify under Section 121. In addition, if a portion of the principal residence is used for rental or business purposes and depreciation is taken, the exclusion does not apply to this portion of the property. Records of capital improvements will be important in this circumstance.
Like many provisions in the Code, the rules of Section 121 are detailed and contain potential traps for the unwary. The benefits of the Section 121 exclusion, however, are great, and we are happy to answer any questions you might have in this area.
Under the new rules, which actually exclude realized gain from taxable income (thus resulting in a tax free sale), the amount of excludable gain is doubled to $500,000 for married individuals filing jointly. Generally, the residence must be owned and occupied as a principal residence for at least two of the five years preceding the sale. The exclusion can be used more than once, provided it is not used more frequently that once every two years. Because of the strict ownership and occupancy requirements of the new law, there are special rules applicable to divorced taxpayers and certain taxpayers suffering unforeseen hardships which would otherwise prevent them from meeting the two year requirement. These hardships include forced changes in employment location, hardship caused by health problems and other unforeseen circumstances not caused by the taxpayer.
There is a corresponding provision under state law which now excludes gain from the sale of a residence from state income tax. Under prior law, subject to certain exceptions, gain on the sale of a home was subject to state income tax.
Because the impact of the new rules can result in substantial tax savings, the timing of a proposed sale can be critical. Assuming you are not forced by circumstance to sell your residence by a particular date, make certain to review the ownership and timing rules under these new provisions to make the most of this new opportunity.
Commentators on the new rules in this area have suggested that it is no longer necessary for homeowners to keep records of capital improvements which increase the basis of a residence (thus reducing taxable gain) on the theory that all of the gain will be excluded. However, we recommend that such records be kept if there is any possibility that a taxpayer might realize income on the sale. This can still occur in several circumstances, including where the residence appreciates rapidly, potentially exceeding the $500,000 exclusion, as well as the circumstance where the owner does not use or own the residence long enough to qualify under Section 121. In addition, if a portion of the principal residence is used for rental or business purposes and depreciation is taken, the exclusion does not apply to this portion of the property. Records of capital improvements will be important in this circumstance.
Like many provisions in the Code, the rules of Section 121 are detailed and contain potential traps for the unwary. The benefits of the Section 121 exclusion, however, are great, and we are happy to answer any questions you might have in this area.
– Cynthia Dixon