John M. Lee: Rising Prices Cause Problems

When we think about rising real estate prices, we think about all the poor buyers out there competing and paying very high prices for properties. But rising prices also create difficulties for sellers.

A few years ago, Congress passed the law that excludes capital gains of up to $500,000 for married couples and up to $250,000 for singles from taxation when the sale involves a principal residence. This meant that the otherwise taxable proceeds from such a sale would not face any taxation unless they exceeded the $500,000 or $250,000 ceiling.

At the time, it seemed incredible that many people would have to face capital gains tax in the sale of his or her primary residence unless an extraordinarily expensive luxury home were involved or did not satisfy the remarkably liberal requirements; that you must own the property at least two years and live in it a cumulative 24 months in the prior five years, and cannot take the exclusion more than once every 24 months. Even with these requirements, under certain circumstances some taxpayers could still take a partial exclusion even if they did not own and live in the property for a full two years.

As this law evolved, some more wonderful changes occurred. We learned that it was even better than it had seemed at first glance. If you have a home office in your primary residence, for example, its value becomes part of the $250,000-$500,000 exclusion. Further, if you own a lot contiguous to the parcel on which your primary residence sits, it too can be folded into the exclusion - even if you don't sell them at the same time as the primary residence, but within 24 months from the sale of the primary residence.

The only new exception to the 24-month rule is if your primary residence was converted from a rental property obtained through a 1031 tax exchange, you must own it for at least five years for it to qualify for the exclusion.

Well, that was then and this is now.

With the price appreciation we have experienced the past few years, many people living in the Richmond and Sunset districts are hitting up against the $250,000 - $500,000 exclusion. How do you minimize your capital gain taxes if you are in this situation? One way is to hold on to all of your receipts involving improvements on your home to decrease your gain. The other way is to see your tax advisor and come up with a strategy to minimize potential taxes.

Some people are longing for the days when homeowners could just trade up without worrying about capital gains taxes. But let's just rejoice that this lenient tax law is still available. Where else can you take a potential $500,000 gain tax-free? This is huge. When President George Bush talks about tax reform, this can be one of the items he is looking at. We know that tax laws change and eventually this one will be modified too. So for those who can take advantage of it now, I would suggest that you consider it.

With prices rising so much, it is hard for someone to trade out of their home because all properties have been increasing in value. In the past, sellers could sell their homes and reinvest the equity to trade-up. Currently, with higher prices, sellers who turn into buyers might have to put in more cash for the down payment and have to sustain a higher mortgage and property taxes for the trade-up home, causing some potential sellers to re-think their positions.

These are some of the difficulties sellers are facing in this rapidly appreciating market. However, let's think of it this way; it is better to have these problems than having your real estate not increase in value.

For most areas in the country, a $500,000 gain only occurs in -ultra-luxury homes. For the property owners in San Francisco, we are fortunate to have to deal with these problems.

John M. Lee is a top selling real estate broker with Pacific Union specializing in the Richmond and Sunset districts. If you have questions regarding real estate, call him at (415) 447-6231 or e-mail johnlee@isellsf.com.