John M. Lee: Principal Residence Tax Rules

Wow, it is extremely interesting to me that a tax law that has been invalid for 10 years still has people confused. It also shows the impact that principal homeownership has on people in the United States.

I am referring to the 1997 tax law change for the capital gains treatment of principal residences.

Prior to 1997, the tax law said if an owner purchases a home of equal or greater value within 24 months of selling his original home, the gain on the sale would be deferred. And if the seller is over the age of 55, he or she can exclude $125,000 of gains from taxes. This can only be used once in a lifetime. This was known as the 1034 exchange and has been totally eliminated since 1997.

This rule was replaced with an even more tax beneficial rule for homeowners.

For the sale of principal residences after May 7, 1997, couples that file their taxes jointly can exclude gains of up to $500,000 from federal income taxes. The limit for a single person or one who is married but filing a separate return is $250,000.

To qualify as a principal residence, the home must have been used as the main residence for the last two out of five years. The two years do not have to be consecutive, which means it could have been the principal residence for the first year, rental the next three years, and then owner occupied again for the last year.

The other change is that someone can use this exemption every two years, instead of the once-in-a-lifetime exclusion provided by the previous law. There are some exceptions in having to live in the property for the minimum two year requirement. If you have some unforeseen life-changing circumstances, such as an employment change outside of the area, divorce or multiple child births, you may be able to sell before the two years are up and take a prorated share of the gain tax-free.

The ones who benefited the most from this new tax law are people with the appreciated properties who were holding back on selling because of huge taxes on gains.

In the Richmond and Sunset districts, there are many seniors whose children have moved out, and who are living in large homes with gains well over the $125,000 exemption limit from the old tax laws.

In the past, if they sold, they would have to worry about capital gains tax. With the new law, they can sell and either buy something smaller or rent, and live off the equity of their home without paying the IRS.

Other benefactors of this law include investors of appreciated single-family homes; they can move from one single-family home to another every two years and sell off the previous ones with no federal taxes. People with vacation homes can also do the same.

Another change in the law recently resulted from the IRS seeing some investors purchasing homes with their 1031 tax exchange funds, eventually moving into the homes to establish principal residency requirements, then selling the homes two year later to avoid any gains. The IRS changed the rule so that if the property was acquired through a 1031 exchange, the holding period must be a minimum of five years.

The only losers from the old tax law are joint filers who have homes with gains of more than $500,000 and single filers with gains of more than $250,000. Upon sale of their home, the taxes on the gain above the exemption limits are due. You cannot exchange to defer or postpone the gains.

If your gain is approaching these limits, it might be advantageous for you to sell your home and buy a similar home in the same neighborhood to lock in the gains without paying taxes.

These rules can be quite confusing and complex initially until you understand them. But once you understand them, they can be used to maximize the gains from your real estate portfolio.

For questions regarding real estate, call John M. Lee at (415) 447-6231 or e-mail him at johnlee@isellsf.com.