John M. Lee: Recent Tax Law Changes

Tax Law Confusions
As I speak with many of my clients who are contemplating selling a piece of property, I find that most people are confused about exchange tax rules.

There are differences when exchanging principal residences and investment properties. In addition, a new law was passed in 1997 for principal residences which eliminated the old rule which most people know, leading to further confusion.

Principal Residences
Prior to 1997, the tax law was that if an owner purchased a home of equal or greater value within 24 months of selling the 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 sales of principal residences starting May 7, 1997, couples that file their taxes jointly can exclude gains of up to $500,000 from federal income taxes. The limit for single, or married filing separate, 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 that it could have been the principal residence for the first year, used as a rental property for 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 once in a lifetime, as was the case with the previous law. In fact, the old law was flawed in that if someone had remarried, and his or her spouse had used the exemption before his or her marriage, he or she could no longer use the exemption again, leading to the term "tainted spouse."

The ones who benefited the most from the new tax law were people with appreciated properties, who were holding back on selling because of huge taxes that would have eaten a good portion of their 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 paying a capital gains tax. With the new law, they can sell and buy something smaller or rent, and live off the equity of their home without paying the IRS.

Other benefactors of the new 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 one with no federal taxes. People with vacation homes can also do the same.

The only losers from the change are joint filers who have homes with gains of more than $500,000 and single filers with gains of more than $250,000. Upon the 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 federal taxes.

Investment Properties
Many investors, when selling, confuse the investment property exchange laws to the old principal residence exchange rules. The timing between the two rules is drastically different. The investment property exchanges are found in the IRS Code Section 1031, and thus are called 1031 tax exchanges.

The exchanges can occur simultaneously, meaning closing the sale and the purchase of a new property can occur on the same day. More often though, the closings occur at different times, and thus the exchanges are called delay or defer exchanges.

In cases like this, the seller has 45 calendar days from the closing of the first property to identify the building(s) he or she will buy and 180 calendar days from the closing of the first property to close on the exchange properties.

In order to defer capital gain taxes completely, a simple rule to remember is that the total purchase price of the property must be larger or equal to the sold property and the mortgage must be larger or equal to the relinquished property. If both of these occur, then taxes can be deferred.

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

John M. Lee is a top selling broker with Pacific Union. If you have any questions regarding real estate, call (415) 447-6231 or e-mail isellsf@aol.com.