John M. Lee: Principal Residence Tax Rules

As I speak with many of my clients who are contemplating selling, 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 for principal residences was passed in 1997, which eliminated the old rule that most people know, thus leading to further confusion.

Principal Residences

Prior to 1997, the tax law stated: 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. It was eliminated in 1997. The exchange rule was replaced with an even more tax-beneficial rule for homeowners. The new rule said: 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 returns 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, rental the next three years, and then owner-occupied again for the last year.

The other major change was that the public could use the exemption every two years, instead of once in a lifetime as provided for in the previous law. The old law was flawed because 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 on the gains. In the Richmond and Sunset districts, there are many seniors (whose children have moved out) 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 worried about the 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 Internal Revenue Service (IRS).

Other benefactors of the law include investors of single-family homes, which have appreciated; 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.

The only losers from this 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 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 with 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 the next property on the same day. More often though, the closings occur at different times, 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 that of the sold property, and the mortgage must be larger or equal to that of the relinquished property. If both of these occur, then the taxes can be deferred.

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

John M. Lee was recently honored as a "top 10 agent" at the GMAC national conference. For questions regarding real estate, call him at (415) 447-6231 or e-mail at johnlee@isellsf.com.