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Capital
Gains President
Bush signed The Jobs and Growth Tax Relief Reconciliation
Act of 2003 (the "2003 Act") on May 28, 2003.
The 2003 Act makes important changes to taxation
laws including, among other matters, lower capital gains
tax rates, acceleration of a reduction in tax rates,
increased child tax credits and a reduction in the
so-called marriage penalty.
Additionally, the Taxpayer Relief Act of 1997 (the
“1997 Act”) and the IRS Restructuring and Reform Act
of 1998 (the “1998 Act”) provide for an exclusion from
income for certain amounts of gain from the sale of a
principal residence.
This Q&A discusses portions of the 2003 Act,
the 1998 Act and the 1997 Act having an impact on capital
gains treatment for the sale of real property and
providing an exclusion from income for gains from the sale
of a principal residence. This
legal memorandum is necessarily general in nature and is
not intended to cover every fact situation. Slightly different facts may produce different results.
Accordingly, parties should consult a professional
tax advisor if advice is needed in connection with a
particular transaction. This
analysis is subject to change as experience is gained with
application of the provisions of the 2003, 1998 and 1997
Acts to actual situations and as the Internal Revenue
Service issues guidance to those provisions. I.
Sale of Principal Residence Q
1. What
happens if I sell my principal residence? A.
Individuals are generally permitted to exclude from
income up to $250,000 ($500,000, in general, for married
couples filing a joint return) realized on the sale or
exchange of their principal residence. Q
2. May
I use this exclusion more than once? A.
Yes, but generally not more than once every two
years. In
order to qualify, you must have owned and used the
property as your principal residence for at least two
years during the five-year period ending on the date of
the sale or exchange.
In addition, the two-year periods do not have to be
continuous. Q
3. May
I use this exclusion in connection with Internal Revenue
Code ("IRC") section 1034 "rollover"
of gain on the sale of my principal residence if I
purchase a home of equal or greater value? A.
No. The
IRC section 1034 provision allowing a delay in the
recognition of gain when purchasing a replacement
residence of equal or greater value was repealed by the
1997 Act. Q
4. May
I still take a one-time
exclusion of $125,000 of gain from the sale of my
principal residence if I am age 55 years or older? A.
No. This
exclusion was also repealed by the 1997 Act. Q
5. If
I have previously used the $125,000 exclusion of gain, am
I prohibited from using the new $250,000 ($500,000 for
married couples filing jointly) exclusion of gain? A.
Generally no.
Even if you have previously taken the one-time
$125,000 exclusion, if you are otherwise eligible for the
exclusion you can take advantage of the $250,000 exclusion
($500,000 for married couples filing jointly) as often as
you meet the requirements. Q
6. How
does the exclusion apply to married couples? A.
The $500,000 exclusion applies to married couples
filing jointly when all of the following conditions are
met: Either
spouse meets the ownership requirement; Both
spouses meet the use requirement; and Neither
spouse has had a sale of their principal residence in the
preceding two years subject to the exclusion. Q
7. What
if I marry someone who has used the exclusion within two
years prior to our marriage? A.
Even though your spouse has used the exclusion
within two years prior to your marriage, you would still
be allowed a $250,000 exclusion.
Once both spouses satisfy the eligibility
requirements and two years have passed since the last
exclusion was allowed to either spouse, a full $500,000
exclusion would be allowed for the next sale or exchange
of a principal residence. Q
8. What
if I move before I have occupied my residence for two
years or before two years have elapsed since the last time
I sold or exchanged my principal residence? A.
If you fail to meet either two-year requirement,
you will still be entitled to a pro rata amount of the
exclusion as long as the failure to meet the requirement
is because the sale or exchange is by reason of a change
in place of employment, health or other unforeseen
circumstances. The
1998 Act provides that this ratio is that portion of the
$250,000/$500,000 exclusion equal to the fraction of the
two years that the ownership and use requirement is met.
Therefore, an unmarried taxpayer who owns and uses
a principle residence for one year and then sells because
of a job transfer may exclude up to $125,000 of gain
(one-half of the regular $250,000 exclusion). Example:
Ms. Seller purchased and occupied her principal residence
in 1998. One
year later, she is transferred by her employer to another
city and sells her house for a $100,000 gain.
Because she occupied her residence for one-half of
the required two years, Ms. Seller is entitled to exclude
up to one-half of the $250,000 otherwise allowed, thereby
covering her entire $100,000 gain.
This is a change from the IRS’s previous position
allowing her to exclude only one-half of her gain, or
$50,000. Q
9. Are
there clarifications to the permissible reasons for sale
or exchange allowing a pro rata exclusion? A.
Yes. Treasury
regulations provide clarifications and safe harbors for
the exemptions from the two-year period.
Treasury Regulation 1.121-3T provides that a sale
or exchange is by reason of a change in employment,
health, or unforeseen circumstances only if the primary
reason for the sale or exchange is a change in place of
employment, health or unforeseen circumstances. The
regulation provides the following guidelines and safe
harbors: Place
of Employment Generally,
a sale or exchange is deemed to be a change in employment
if the primary reason for the sale or exchange is a change
in the location of a qualified individual’s place of
employment. (See
Question 10 for a definition of
qualified individual.) The
regulation provides a distance safe harbor if (i) the
change of employment occurs during the period of the
taxpayer’s ownership and use of the property as the
taxpayer’s principal residence, and (ii) the
individual’s new place of employment is at least 50
miles further from the residence sold or exchanged than
was the former place of employment, or, if there was no
former place of employment, the distance between the
individual’s new place of employment and the residence
sold or exchanged is a least 50 miles. For
purposes of the regulation, employment includes starting a
job with a new employer, continuing employment with the
same employer, and starting or continuing self-employment. Health A
sale or exchange is by reason of health if the primary
reason for the sale or exchange is to obtain, provide, or
facilitate the diagnosis, cure, mitigation, or treatment
of disease, illness, or injury of a qualified individual,
or to obtain or provide medical or personal care for a
qualified individual suffering from a disease, illness or
injury. A
sale or exchange that is merely beneficial to the general
health or well-being of the individual is not a sale or
exchange by reason of health. The
regulations provide a safe harbor if a physician
recommends a change of residence for reasons of health.
(See Question 10 for a definition of qualified
individual.) Unforeseen
Circumstances A
sale or exchange is by reason of unforeseen circumstances
if the primary reason for the sale or exchange is the
occurrence of an event that the taxpayer does not
anticipate before purchasing and occupying the residence. The
regulations provide a safe harbor for any of the following
events occurring during the taxpayer’s ownership and use
of the residence as the taxpayer’s principal residence: 1.
The involuntary conversion of the residence; 2.
Natural or man-made disasters or acts of war or
terrorism resulting in a casualty to the residence; 3.
In the case of a qualified individual: a.
Death; b.
The cessation of employment as a result of which
the individual is eligible for unemployment compensation; c.
A change in employment or self-employment that
results in the taxpayer’s inability to pay housing costs
and reasonable basic living expenses for the taxpayer’s
household (including amounts for food, clothing, medical
expenses, taxes, transportation, court-ordered payments,
and expenses reasonably necessary to the production or
income, but not for the maintenance of an affluent or
luxurious standard of living); d.
Divorce or legal separation under a decree of
divorce or separate maintenance; e.
Multiple births resulting from the same pregnancy;
or 4.
An event determined by the Commissioner to be an
unforeseen circumstance to the extent provided in
published guidance of general applicability or in a ruling
directed to a specific taxpayer. (See
Question 10 for a definition of
qualified individual.) Q
10. Who is a
“qualified individual”? A.
Qualified individual is defined in the regulations
as the taxpayer, the taxpayer’s spouse, a co-owner of
the residence, or a person whose principal place of abode
is in the same household as the taxpayer.
For purposes of the pro-rata exclusion of gain for
a sale or exchange due to health only, a qualified
individual also includes (i) an individual with a
relationship described as a dependent in IRC section
152(a)(1) through (8), without regard to whether they are
actually a dependent, or (ii) a descendent of the
taxpayer’s grandparent. Q
11. What if I
do not qualify for a safe harbor? A.
The regulations provide the following factors,
which may be relevant in determining the taxpayer’s
primary reason for the sale or exchange: 1.
The sale or exchange and the circumstances giving
rise to the sale or exchange are proximate in time; 2.
The suitability of the property as the taxpayer’s
principal residence materially changes; 3.
The taxpayer’s financial ability to maintain the
property materially changes; 4.
The taxpayer uses the property as the taxpayer’s
residence during the taxpayer’s ownership of the
property; 5.
The circumstances giving rise to the sale or
exchange are not reasonably foreseeable when the taxpayer
begins using the property as the taxpayer’s principal
residence; and 6.
The circumstances giving rise to the sale or
exchange occur during the period of the taxpayer’s
ownership and use of the property as the taxpayer’s
principal residence.
Q
12. May I
deduct a loss on the sale of my principal residence? A.
No. Although
there were discussions about allowing homeowners to deduct
losses on the sale of their principal residence, this
provision did not become law. Q
13. If I have
gains from the sale of my principal residence above the
$250,000/$500,000 exclusion limits, what tax rate will I
pay? A.
Depending on the length of time you owned your
principal residence, your gain may be taxed at the more
favorable capital gain rates discussed below.
See Section II, below. Q
14. Are there
more special rules? A.
Yes, including, among others, the following: A
taxpayer can elect not to have the exclusion apply to any
sale or exchange. Certain
periods an individual resides in a nursing home on account
of physical or mental incapacity are included as part of
the two-year use requirement if certain other rules apply. An
individual whose spouse is deceased on the date of the
sale of the property can include the period the deceased
spouse owned and used the property before death. An
individual is treated as using the property as his or her
principal residence during any period of ownership while
the individual's spouse or former spouse is granted use of
the property under a divorce or separation instrument. Q
15. What
happens if I transfer my principal residence into a
revocable living trust? A.
IRC section 676 provides that a grantor (the person
who creates and funds the trust) is treated as the owner
of the property when the grantor retains the power to
revoke the trust and revest title in him or herself.
The 2003 Act does not change this provision. This means that the $250,000 exclusion ($500,000 if married
filing jointly) applies to a sale or exchange by a
revocable living trust so long as the grantor of the trust
and owner of the property before it was conveyed to the
trust are the same person and that person, either as owner
or grantor, has owned and used the property as his or her
principal residence for two of the previous five years.
In other words, because the grantor is still
treated as the owner of the property, the transfer into
the trust is not a taxable event. Q
16. May I
utilize an IRC Section 1031 (tax-differed exchange) in
connection with an owner-occupied residence? A.
No. However, individuals sometimes exchange one
rental property for another planning to move into the
acquired property and, after living in it for two years,
sell it and take advantage of the capital gains exclusion.
This sometimes occurred as soon as three or four years
after the acquisition.
As of October 22, 2004, this is no longer possible.
Pursuant to the American Jobs Creation Act (signed by
President Bush on October 22, 2004), a property acquired
in a 1031 exchange and later converted to a principal
residence must by owned for five years from the date of
the exchange before the owner can claim the capital gains
exclusion. Therefore, in order to take advantage of a 1031
exchange and the capital gains exclusion, the owner must
both have used the acquired property as a principal
residence for two years and owned it for five years. II.
Capital Gains Q
17. What are
the basic changes to the capital gains tax structure? A.
Basically, the 2003 Act reduces the maximum rate on
the net capital gains rate of an individual (net long-term
capital gains less net short-term capital losses) from 20
percent to 15 percent.
Net capital gains previously taxed at 10 percent
will be taxed at 5 percent. Q
18. Has the
holding period for long-term capital gains changed? A.
In order to qualify for long-term capital gains
treatment, property must be held for more than 12 months. Q
19. Are there
further capital gains tax rate reductions? A.
In 2008, the capital gains tax rate for gains taxed
in the lowest tax bracket (5 percent) will be reduced to
zero. Q
20. When do the reductions in capital gains take effect? A.
The 2003 Act took effect May 6, 2003 and applies to
taxable years ending on or after May 6, 2003.
There are special transitional taxation rules for
taxable years including May 6, 2003. Q
21. Do these
capital gains rates expire? A.
Unless Congress extends them, the capital gains
rate reductions will sunset December 31, 2008, at which
time the rates will revert to 20 percent and 10 percent. Q
22. Are there
any changes to depreciation recapture rules? A.
No. Generally,
when selling investment real property, a tax is imposed on
all amounts previously taken as depreciation.
Under prior law, these amounts were taxed as
ordinary income and not capital gains. The
1997 Act provides for a 25 percent maximum tax rate on any
gain attributable to depreciation already claimed on the
property in the case of real property for which the
maximum tax rate is reduced to 15 and 5 percent.
Although there was an effort to reduce the
recapture rate, no reduction materialized. Example:
Ms. Seller purchases a triplex for $200,000 after
January 1, 2001, and takes depreciation deductions of
$50,000 over the six years she owns it. She sells the duplex for $300,000. Her basis in this property is reduced to $150,000 because of
her deductions for depreciation, and she would have a
$150,000 gain. Under
the 2003 Act, she would be taxed at a 15 percent (or 5
percent) rate on the $100,000 portion of gain over her
original $200,000 basis and at a 25 percent rate on the
$50,000 portion of gain attributable to her depreciation
deduction. Q
23. Can you
provide a summary of the capital gains tax rates? A.
Yes. Sales of assets held more than 12 months and
sold on or after May 6, 2003 qualify for the 15 percent
capital gains rate (5 percent for lowest income
taxpayers), with special transitional rules for sales in
taxable years including May 6, 2003.
The capital gains rate reverts to 20 and 10
percents for assets held for more than 12 months and sold
after December 31, 2008. Q
24. Can I
still take advantage of an IRC section 1031
"like-kind" exchange? A.
Yes. The
tax-free exchange of
"like-kind" property used in a trade or
business is not affected by the Act. Recent
changes to real estate tax laws may affect the decisions
of California's homebuyers and sellers. The Internal
Revenue Service (IRS) has imposed a five-year ownership
requirement to qualify for the $250,000 (or $500,000 for
married couples) exclusion from capital gains taxes for
properties acquired through a 1031 exchange. In a separate
move, California's Franchise Tax Board has eased its real
estate withholding requirements by no longer requiring one
as long as the seller last used the property being sold as
his or her principal residence. |
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