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home sale exclusion

Q&A: Living in your rental? The tax benefits aren’t so clear cut

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Dear Liz: My husband and I have owned a rental property for 20 years. We’ve never lived in it. Now, we want to get out of the landlord business. We know we’ll have to recapture depreciation, but we always thought we could live in the property for a couple of years to save some on the capital gains taxes. Our accountant has told us that this is no longer true and we cannot save much by living in our rental. Federal and state taxes will take most of our profit. Is this true?

Answer: Congress dramatically shrank the loophole that once allowed people to reduce or eliminate capital gains on rental and vacation properties.

When selling a primary residence, homeowners can shelter up to $250,000 of home sale proceeds, or $500,000 for married couples, from capital gains tax if they’ve owned and lived in the home at least two of the previous five years. Those rules were established in the Taxpayer Relief Act of 1997.

Before the Housing Assistance Tax Act of 2008, landlords could move into their rentals for a couple of years, sell the properties and then invoke the home sale exclusion as if the property had been their primary residence all along.

Today most if not all of the gain on your property is considered “non-qualified use.” Only the appreciation you experienced before 2009, and after you move in, would qualify for the exemption.

The benefits of moving into a rental for a couple of years can vary greatly, depending on the specifics of your situation. Your tax pro can walk you through the math and advise you about some of your other tax-saving options, such as a 1031 exchange for another rental property or holding the real estate until death, when your heirs would benefit from a valuable step-up in basis. If you’re done with being a landlord, though, the cleanest solution might be to simply sell and pay the tax.

Q&A: Can I avoid capital gains by buying another house?

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Dear Liz: We are in our 70s and have owned a home in the San Francisco Bay Area for 30 years, so as you might imagine we have a sizable capital gains issue. We are starting to think about a “next step.” While I understand we would have a $500,000 exclusion and can “back out” any improvements, we would still be looking at a pretty hefty number.

We’ve had some people tell us that we would be able to take advantage of a one-time exclusion for the whole gain, but I certainly haven’t been able to find anything about this. I know if we purchase another home in California, we can keep our existing property tax basis, but in the scheme of things, that’s not a major benefit.

Any idea what these folks might be talking about?

Answer: They’re talking about an option that disappeared not long after you purchased your home. Some people are under the illusion that the old tax break still exists, because versions of this question seem to hit my inbox at least once a year.

Before Congress changed the law in 1997, homeowners could defer taxes on home sales by purchasing another house of equal or greater value. Those 55 and older could take a one-time exemption of $125,000.

That was replaced by rules allowing homeowners to exempt up to $250,000 each (or $500,000 for a married couple), limits that haven’t been updated since.

When the law was passed, few home sellers had enough capital gains to worry about exceeding the exemptions. Consider that the median home sale price in the Bay Area was just under $300,000 in 1997. Last year, the median was about $1.2 million.

A sizable capital gain doesn’t just deliver a painful tax bill. Your Medicare premiums may also temporarily increase, thanks to IRMAA, the income-related monthly adjustment amounts.

One more thing: please don’t dismiss the value of California’s Proposition 19, which allows homeowners aged 55 and over to transfer their property tax basis to a new home.

Your property tax bill is dramatically lower than what you’d pay if you were buying into your neighborhood today. That’s thanks to California’s earlier Proposition 13, which limits annual property tax increases.

A home purchased for $300,000 30 years ago probably has an annual property tax bill today of around $7,000. That same house, if purchased now for $1.2 million, would generate a tax bill of around $15,000.

Your ability to transfer your tax basis means you can save thousands of dollars annually for the rest of your life. That would be a huge benefit in most people’s scheme of things.

Q&A: Home sale tax rules confuse many

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Dear Liz: I thought I understood about taxes and house sales, but I am now confused. It seems like the previous rules were that home sale profits could be rolled from one house to the next and one would take a one-time exemption for up to $500,000 or so, with capital gains only due on the amount above that amount. Now the latest rule is that house sales are calculated on each sale, but still based on purchase price plus improvements as the basis. Or is it?

Answer: You are confused, but you’re not alone. Many people remember the old rules, and some think they’re still in effect.

The basic way that capital gains are calculated hasn’t changed. The homeowner’s tax basis — which is the amount they paid for the home, plus qualifying improvements — is subtracted from the net sale price to determine potentially taxable capital gains.

Before the Taxpayer Relief Act of 1997, homeowners could defer capital gains on home sales if they bought a replacement house of equal or greater value. At age 55, they could take a one-time exemption that protected $125,000 of home sale gains from taxation. This allowed many if not most people to downsize without owing big tax bills (the median home price in 1997 was less than $150,000).

The rules today are quite a bit different. Home sellers can exclude up to $250,000 of capital gains, or $500,000 for a married couple, as long as they owned and lived in the home at least two of the five years prior to the sale.

Note, however, that the exclusion amount hasn’t changed since 1997. The median home price in the U.S. is over $400,000, and “starter” or entry-level homes top $1 million in over 200 cities, according to real estate site Zillow. That means many more longtime homeowners face capital gains taxes when they sell their homes.

Q&A: Widow may be eligible for home sale tax relief

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Dear Liz: My late husband and I bought my present home in 1969. I am now 80. From what I understand, my widowed status does not make any difference in regard to the home sale exemption. His death means that when I want or need to sell the house, I lose out on half the $500,000 home sale exemption we otherwise would have received. I have not discovered any exceptions for the elderly widow or widower. Does such a relief exist?

Answer: If you sell the house within two years of a spouse’s death, you can qualify for the full $500,000 home sale exclusion, assuming you meet the other criteria for this tax break, such as owning and living in the home as your primary residence for at least two of the past five years, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. This assumes the surviving spouse has not remarried and neither spouse claimed the exclusion within two years before the sale.

If more than two years have passed, you still may get more tax relief than you think. In most states, when a spouse dies, one-half of the home gets a favorable “step up” in tax basis to the current market value. In California and other community property states, both halves of the house get this step up.

Let’s say you and your husband bought your home for $25,000 in 1969 and spent $75,000 on home improvements over the years, creating a tax basis of $100,000. Let’s further say the house was worth $600,000 when he died. In most states, your half of the house would retain its tax basis of $50,000. His half would be stepped up to $300,000, or half the then-current market value. Together, the tax basis would be $350,000. If you sold the house for $650,000, your home sale profit would be $300,000. You could subtract the $250,000 exemption from that, leaving you with a $50,000 capital gain.

If you live in a community property state, however, your tax basis would be $600,000 after your husband died, since both halves got the step-up. If you sold for $650,000, your exemption would more than offset the $50,000 profit and you would owe no capital gains taxes.

Q&A: Selling a house? Don’t confuse the tax rules

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Dear Liz: We read your recent column about capital gains and home sales. Our understanding is that if you sell and then buy a property of equal or greater value within the 180-day window, the basis for tax purposes is the purchase price, plus the $500,000 exemption, plus the improvements to the property, minus the depreciation, whatever that number comes to, and then the profit above that has to be reinvested or it is subject to capital gains. We talked to our CPA about this and he referred us to a site that specializes in 1031 exchanges.

Answer: You’ve mashed together two different sets of tax laws.

Only the sale of your primary residence will qualify for the home sale exemption, which for a married couple can exempt as much as $500,000 of home sale profits from taxation. You must have owned and lived in the home at least two of the previous five years.

Meanwhile, 1031 exchanges allow you to defer capital gains on investment property, such as commercial or rental real estate, as long as you purchase a similar property within 180 days (and follow a bunch of other rules). The replacement property doesn’t have to be more expensive, but if it’s less expensive or has a smaller mortgage than the property you sell, you could owe capital gains taxes on the difference.

It is possible to use both tax laws on the same property, but not simultaneously.

In the past, you could do a 1031 exchange and then convert the rental property into a primary residence to claim the home sale exemption after two years. Current tax law requires waiting at least five years after a 1031 exchange before a home sale exemption can be taken.

You can turn your primary residence into a rental and after two years do a 1031 exchange, but you would be deferring capital gains, while the home sale exemption allows you to avoid them on up to $500,000 of home sale profits.

Q&A: Time to move, but what about the capital gains?

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Dear Liz: My husband and I built a home on a hillside over 30 years ago in a desirable neighborhood with a beautiful view. We thought it would be our retirement home, but life had different plans. Now seniors, dealing with age, stairs and progressive health issues, we have been advised that selling and moving to a senior assisted living facility is the best option for us before we are forced by circumstances to move. And, we were told, it would be less expensive than having full-time, in-home care.

We are concerned that capital gains would take a big chunk out of the sales proceeds from our home, and that’s money we need to pay for assisted living. Can we use the purchase price of the vacant lot against the capital gains? Can we use the bank loan for building the house against the capital gains? Can we use the cost of an apartment or condo in an assisted living residence against the capital gains? What other things can be used against capital gains other than general home improvements?

Answer: A large gain wouldn’t just reduce the amount of money you have for the next phase of your life. It also could increase your Medicare premiums for a year, thanks to the income-related adjustment amount or IRMAA.

You’ll determine your potentially taxable capital gains by deducting your tax basis from your home sales proceeds. Your basis includes the purchase price of the lot and the cost of construction, plus any qualifying home improvements you’ve made over the years.

The two of you can shelter up to $500,000 of home sales profits from capital gains taxes. Capital gains also can be reduced if you have capital losses — in other words, if you’ve sold stocks or other assets for a loss.

What you do with money doesn’t affect the capital gains taxes you pay. Decades ago, you could defer capital gains by buying another home of equal or greater value, but that’s no longer the case.

You may have some alternatives to lessen the impact of the gains, such as an installment sale where the buyer pays over time. Another option would be renting out rather than selling your home.

A tax pro can provide guidance.