Querin Law: Tax Tips When Selling A Primary Residence

BooksIntroduction.  For the last several years, the concept of “equity” [i.e., the difference between the net proceeds received upon sale and the unpaid mortgage balance] that many people counted upon when they sold their home, was moot or close to moot – there was none. However, as we slowly climb out of the Great Recession, and read the housing stats, since 3Q 2012, most homes in the Portland-Metro area have been steadily appreciating. Accordingly, it seems timely to focus upon the issue of taxes. The Taxpayer Relief Act of 1997 (“the Act”), which was signed on August 12, 1997, effected several important changes in estate and gift taxes, individual retirement accounts, charitable giving and capital gains rates.  Included in the new law was a major revision in how the sale of personal residences were to be treated for income tax purposes. The New Law and  Tax Tips, discussed below, apply to residential sales transaction occurring on or after May 7, 1997.

The Old Law.  Before the Act, the only way to avoid paying income tax on the gain from the sale or exchange of a primary residence was to acquire another primary residence of equal or greater value within two years before or after disposing of the replaced residence.  The taxable gain[1] was not eliminated, but merely deferred by being “rolled over” to the next primary residence purchased.  Eventually, the entire deferred gain was paid by the taxpayer or the taxpayer’s estate. The only complete relief from payment of taxable gain came in the form of a one-time $125,000 exclusion available to homeowners who were age 55 or over. Since a primary residence is a “capital asset,” its sale or exchange was taxed at “capital gains rates” which were capped at 28%.  However, this rate was sufficiently high that only taxpayers whose ordinary income tax rates were higher (i.e. the 31% bracket and above) received any real tax savings.

The New Law.  Simply stated, the two year “rollover” provisions and the $125,000 lifetime exemption have been discarded.  The new rules will apply to sales of a primary residence only – not secondary or vacation residences:

  • $500,000/$250,000 Exclusion.  The first $500,000 of gain is excluded for joint filers who sell their primary residence. For single filers, the exclusion is $250,000.  The excess above the applicable $500,000 or $250,000 exclusion will be taxed at the applicable capital gains rate.
  • Holding Period.  In order to qualify, the property must be used by the taxpayer as a primary residence for an aggregate for two of the last five years.
  • Capital Gains Rates.  The excess above the $500,000/$250,000 exclusion is taxed at the applicable capital gains rate. According to the IRS: Generally, for most taxpayers, net capital gain is taxed at rates no higher than 15%. Some or all net capital gain may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets. However, beginning in 2013, a new 20% rate on net capital gain applies to the extent that a taxpayer’s taxable income exceeds the thresholds set for the new 39.6% ordinary tax rate ($400,000 for single; $450,000 for married filing jointly or qualifying widow(er); $425,000 for head of household, and $225,000 for married filing separately). For more information, refer to Publication 505Tax Withholding and Estimated Tax. However, don’t forget that Oregon is one of the few states with an income tax. This means, of course, that upon the sale of a capital asset, e.g. a primary residence, there will be an additional capital gains tax.  According to OregonLive.com:

Yet Oregon’s tax structure, which taxes capital gains at the standard income rate, is famously unfriendly to investors and small business owners alike. For long-term capital gains, Oregon’s top combined federal and state rate, 21.4 percent, is higher than every other state’s except California’s (21.7 percent) and Hawaii’s (22.2 percent), according to a March study by the American Council for Capital Formation, a Washington, D.C.-based organization that advocates for low taxes on capital gains.

Tax Tips. Despite its rather simple explanation, there are a variety of specific issues raised by the capital gains rules. Here are a few tips:

  • Rolled over gain from prior sales of a primary residences. The $500,000/$250,000 exclusion will be calculated against the accumulated net gain going back to the first home purchase.  Ignoring any adjustments to the initial cost basis, if an owner’s first home was acquired in 1975 for $40,000 and sold for $65,000 and the second residence was purchased for $100,000 and sold for $150,000 the tax basis for the third and current home would be the $40,000 purchase price of the first home.  If the third home was sold for $350,000, the total net capital gain subject to exemption would be $310,000 ($350,000 – $40,000).
  • Subsequent residences.  Today, it makes no difference whether the funds from the gain are actually “rolled over” into another primary residence.  Each time the homeowner sells their primary residence they must qualify for the exemption.  If the homeowner purchases a subsequent residence, it makes no difference that it did not cost more than the prior home.  In other word, in order to qualify for the $500,000/$250,000 exemption, one does not have to “buy up.”  Each transaction stands on its own.  Thus, for homeowners that qualify for the holding and ownership periods, the first $500,000/250,000 of net gain is exempted from income tax, regardless of whether (a) a subsequent home is purchased, or (b) the price of that home.
  • If the one-time $125,000 exemption has already been used Owners who have already used their one-time $125,000 exemption will still qualify for the $500,000/250,000 exemption, but not until they have lived in the home for two years from the date of purchase.
  • Converting the primary residence into a rental. Entitlement to the $500,000/$250,000 exemption is not lost by moving out of the home and renting it, so long as the homeowner lived there for two of the last five years before resale.
  • Ownership by one spouse.  A husband and wife, filing jointly, may obtain the combined $500,000 exemption if they have both lived in the home for two of the last five years.  Only one spouse needs to be the owner during that same time.
  • Investing in a primary residence every two years.  Homeowners may purchase a residence, make substantial improvements while living in it for two years, resell it and avoid paying tax on the gain up to $500,000 for joint filers and $250,000 for single filers.  There is no limit to the number of times a homeowner may qualify for the exclusion, so long as the ownership and occupancy requirements are met.
  • Unmarried joint owners.  If the joint owners have both resided in the home for two of the last five years and it is their primary residence, upon resale they will each have an exclusion of up $250,000 of taxable gain on their separate return.
  • Same sex marriage.  The U.S. Department of the Treasury and the Internal Revenue Service has ruled that same-sex couples, legally married in jurisdictions that recognize their marriages, will be treated as married for federal tax purposes. This ruling applies regardless of whether the couple lives in a jurisdiction that recognizes same-sex marriage or a jurisdiction that does not recognize same-sex marriage. [For details go to link here.]             

Conclusion and Caveat. The entire tax law regarding the sale of a primary residence is found at IRC 121, here. Each factual situation can lead to different tax treatment.  For answers to specific questions, homeowners should obtain the services of a qualified tax professional.

[1] It which was measured by the difference between the gross selling price and the initial purchase price, as adjusted by adding the cost of capital improvements such as structural additions to the home and certain other closing and transactional costs.