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Questions & Answers on Capital
Gains
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Has the
tax bill signed by the President on August 5, 1997
impacted the real estate industry? Yes! The bill
made significant changes that benefit real estate
including capital gains tax exclusions on the sale of
a principal residence, a reduction in overall capital
gains rates, penalty-free withdrawals from existing
and new IRA’s for the purchase of a home by a first
time buyer, increased deductions for health insurance
premiums for the self employed, clarifications of the
home office deduction requirements and reduced estate
taxes.
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If I
sell my home how will I be impacted?
The new tax bill grants married couples up to a
$500,000 capital gains tax exclusion for the sale of a
principal residence where the owner has resided two of
the last five years. Singles enjoy a $250,000
exclusion. Any profits in excess of the caps will be
taxed at the new lower capital gains tax rate. Best of
all, this principal residence exclusion can be reused
over and over again. Homesellers who have owned and
lived in their homes for less than two years qualify
for a smaller tax exclusion based on length of
ownership/residnece.
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Can I
still “rollover” the proceeds from a home sale if
I purchase a home of greater or equal value?
No. The “rollover” provision in current law
which allowed an individual to avoid capital gains
taxes by purchasing a home of equal or greater value
has been repealed in favor of the exclusion.
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What if
I am over 55 years of age and I already used my
one-time exclusion of $125,000? Can I take advantage
of the new law?
Yes. Although the $125,000 exclusion for
individuals over the age of 55 has been repealed, the
new law allows any couple, regardless of age, to
exclude from taxes up to $500,000 in capital gains or
$250,000 for singles every two years for an unlimited
number of transactions involving their principal
residence.
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I sold
my home before the President signed the bill. Do I
still qualify for a capital gains tax exclusion?
Maybe. Sellers and buyers who have signed a
“binding contract” between May 7, 1997 and the day
President Clinton signed the bill (August 5) are
authorized to use either the existing rollover law or
take advantage of the new tax provisions. Individuals
who completed the sale of their home prior to May 7,
1997 are bound by the tax laws in effect at that time.
For home sales after the August 5 date, the new tax
laws are applicable.
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Are
losses on the sale of a residence deductible?
No. Taxpayers still cannot deduct losses on the
sale of their residence.
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What
are the new capital gains rates?
Capital gains rates are based on an individual’s
taxable income. Under the new law, capital gains rates
are lowered from the previous rate of 28% to 20% for
those in upper income brackets and from 15% to 10% for
those in lower tax brackets for assets sold after May
6, 1997. Overall capital gains rates will be lowered
even further in 2001, to 18% and 8% respectively, for
assets purchased after December 31, 2000 and held five
years or more. No indexing of capital gains were
included.
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How
long is the holding period for assets to qualify for
capital gains tax treatment?
Thanks to the IRS Restructuring and Reform Act of
1998, assets held 12 months are eligible for capital
gains treatment.
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Is
investment property taxed differently than other
assets under the new bill?
The new budget plan specifies that at the time of
sale of an investment property, any gains due to
appreciation will be taxed at a reduced 20% rate and
gains due to “depreciation recapture” will be
taxed at 25%.
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Have
the rules governing 1031 “like kind” exchanges
changed?
No. Despite reports that these rules might have
been significantly changed, no provisions were
included in the bill.
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Can I
withdraw money from my Individual Retirement Accounts
(IRAs) for the purchase of a home?
The tax bill allows penalty-free withdrawals by
grandparents, parents, children, spouses or principals
of up to $10,000 from existing and newly created
“American Dream” IRAs for the down payment and
closing costs of purchasing a first-time home, after
December 31, 1997.
ALL OF THESE MATTERS ARE SUBJECT TO
REGULATORY INTERPRETATION. PLEASE CONSULT YOUR TAX
ADVISOR.
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How not to pay capital gains tax on
the sale of rental, investment or a vacation property
With the right knowledge, information, and
patience, you can make the taxable gain from the sale of a
rental property or a vacation home completely disappear.
How? Simply convert the property to a primary residence,
use it as such for the appropriate period of time, and
then sell it for a tax-free gain. Simple as that. Well,
it's a bit more complicated, but you can read more about
the rules for tax-free treatment on the gain of a
principal residence in my series of articles entitled Home
Sale Exclusions in the Taxes FAQ area. You'll also
want to read more about the rules regarding the home sale
gain exclusion in IRS
Publication 523 to make sure that you've got all your
bases covered. If done correctly, there are some large
tax-saving opportunities out there.
How It Works
The key to the entire plan is that you are allowed to sell
a principal residence once every two years and exclude up
to $250,000 ($500,000 for a married couple) of the gain on
the sale. So, to get
the maximum bang for your buck, you'll want to understand
the rules and have the patience to wait out the two-year
residence period. For those of you with substantially
appreciated real estate in the form of investment
properties or second homes, the tax savings could be worth
the wait. Let's look at a few examples.
Rental Conversion
Mary has a residence and a rental property. Both have
substantially appreciated in value. Mary sells her primary
residence, takes her capital gain exclusion of up to
$250,000 on that residence, and decides to move into the
rental unit. The rental unit now becomes her primary
residence.
Mary resides in the rental unit for another two years to
qualify for the ownership and use tests. Mary then sells
the property and realizes a substantial gain... of which
up to $250,000 can be excluded under the law. Poof...
gone.
It makes no difference that most of the appreciation on
the second property was realized when it was a rental
unit. It also makes no difference that much of the taxable
gain is attributable to depreciation that Mary claimed as
a deduction against the property in prior years. Mary met
all of the tests to exclude the gain and is therefore
eligible to do so. Mary has used the tax laws to her
advantage. She planned her life to rid herself of some
substantial taxes. Nothing illegal or immoral about that.
A Word on Depreciation
It should be noted that all of Mary's gain might not
be excluded. Why? Because depreciation taken on the rental
property after May 6, 1997 will be subject to
"recapture" and tax. But only the depreciation
taken after May 6, 1997 will be subject to recapture. Any
depreciation taken before that date will be
"forgiven" and will be available for the gain
exclusion.
Even with this minor inconvenience of recognizing gain on
the depreciation claimed after May 6, 1997, the conversion
of a rental property to a primary residence likely still
makes sense from a tax standpoint. Heck, it seems like a
very small price to pay to exclude up to $250,000 (or
$500,000 on a married/joint return) of gain.
Retirement Planning
Jack and Jill are thinking about retirement in the near
future and want to relocate to a "dream"
community in another part of the country. They're afraid
that if they wait until retirement to sell their current
home, buy a retirement home, and move to the retirement
community, that the "hot" real estate market
might push the cost of their retirement home out of reach.
So, they decide to purchase the property now and rent it
out until they finally retire and move. They'll still
receive the gain exclusion on their current home when they
decide to sell, and they can move into their retirement
home and establish it as their new primary residence.
If the retirement area isn't as "dreamy" as they
first thought, all they'll have to do is meet the two-year
residence test before selling the property to exclude up
to $500,000 of the gain (save for any depreciation taken)
and move on. Poof... gone. They might make a mistake with
the selection of their retirement home, but at least they
won't have to add insult to injury by paying any taxes on
the gain.
The Reverse Rental Gambit
Bill originally bought his home in 1997 and relocates
across the country in 2000 to take a new job stuffing
those little fortunes into the cookies. He's not sure if
this new job will work out. So, instead of selling his
current residence, he decides to rent it out. Bill figures
that if he doesn't like stuffing cookies, he can always
return to his old home, so renting his home provides a
safety net.
Two-and-a-half years later (mid-2002), Bill has climbed
the corporate ladder and is in charge of putting those
little almonds on top of the cookies. He decides he likes
his new job and location and wants to sell his old home --
the one that is now a rental. He does... and is able to
exclude up to $250,000 of the gain on the sale (save for
the depreciation taken). Poof... gone.
How is this possible? The law says that the property must
be used as a principal residence for at least two years
during the five-year period ending on the date of the sale
of the residence. So even though Bill hasn't lived in the
home for the last two-and-a-half years, he did use it as a
principal residence for two years during the five-year
period ending on the date of the sale. So Bill's gain is
subject to the exclusion. Sweet.
These are but a few examples of how the gain exclusion
rules can work for you. There are many others. Tax-saving
opportunities exist for married people living apart in two
separate homes, for people contemplating divorce, for the
elderly who may have moved into an extended-care facility
for a period of time, and any number of other different
combinations. So, make sure that you can be the best
magician that you can be. Understand the rules regarding
the sale of a principal residence and make those gains
disappear. Poof... gone.
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Abstract- An
overview of the capital gains tax implications when
changing the status of a property from a rental dwelling
to a primary residence dwelling indicates that the
change is treated as a sale of the property, making
capital gains deferment subject to a mandatory waiting
period. If a residence is sold and replaced with a new
one, the total capital gain during the ownership can be
deferred as a reduction of the cost of the new residence
if the owner lived there for two years following the
sale, and the new residence is bought within two years
after the sale. If the conditions are not met, the
entire capital gain is considered ordinary income for
taxation purposes.
During ownership, a property must be used as a rental
property or as a principal residence. Capital gains tax
implications upon a change in status of the property from
rental property to principal residence are the focus of
this article.
As a Rental Property
As a rental property any gain on sale must be treated
as ordinary income regardless of the length of holding
period and whether it is the first sale or a subsequent
sale (except for the exchange of like-kind assets). That
is because rental property is treated as a business asset.
On the other hand, as a principal residence, the gain
on the sale is not recognized as long as the next purchase
of a residence is made within two years after the last
sale, except for the case where the adjusted sale price of
the old residence exceeds the cost of the new one. In such
a case, capital gain is recognized to the extent of this
excess Sec. 1034(a). The non-recognized capital gain on
the old residence is deferred to serve as a reduction of
the cost of the new one, but this reduced cost of the new
residence must not be lower than the cost of the old
residence. This treatment is always true no matter how
long the old residence had been held.
If the owner of a principal residence acquired a new
residence within two years after the sale of the old
residence, the capital gain on the first sale can be
deferred. However, if this taxpayer again sold the new
residence less than two years after the first sale, and
purchased a third residence, the capital gain between the
price of the second sale and the cost of the new residence
can no longer be deferred to serve as a reduction of the
cost of the third residence. However, the capital gain on
the first sale for the difference between the price of the
first sale and the cost of the old residence can still be
deferred to serve as a reduction of the cost of the third
residence Sec. 1034(d). The only exception to this rule is
the situation where the second residence was sold due to
employment relocation. The two-year waiting time does not
apply to the first sale. In other words, the homeowner can
own a first residence for less than two years, sell it and
replace it, and is still entitled to the deferral of
capital gain.
Example: Mr. Jones purchased residence No. 1 on January
1, 1980 for a cost of $100,000. On July 1, 1980 he sold
residence No. 1 for a price of $110,000. On August 1, 1980
he purchased residence No. 2 for a cost of $130,000. On
February 1, 1981 he sold his residence No. 2 for a price
of $160,000. On March 1, 1981 he purchased residence No. 3
for a cost of $200,000. What is the taxable capital gain
in 1980 and 1981, respectively? And what is the basis of
residences No. 2 and No. 3 respectively? See Figure 1.
The taxable capital gain in 1980 is zero because the
entire $10,000 gain ($110,000 - $100,000) is deferred even
though Mr. Jones owned his residence No. 1 for less than
two years. As a result, the basis of residence No. 2 is
$120,000 ($130,000 - $10,000). The total accounting
capital gain on the sale of residence No. 2 in 1981 is
$40,000 ($160,000 - $120,000). However, since he waited
only seven months (from July 1, 1980 to February 1, 1981)
which is less than the required two years of waiting
period after the first sale (July 1, 1980), the $30,000
($160,000 - $130,000) capital gain on the sale of
residence No. 2 cannot be deferred. The $10,000 capital
gain on the sale of residence No. 1 can be deferred. As a
result, the taxable capital gain in 1981 is $30,000
($40,000 - $10,000). The basis of residence No. 3 is
$190,000 ($200,000 - $10,000).
If, during the period of ownership, the status of
principal residence was changed to the status of rental
property, and the property was thereafter sold, the total
capital gain throughout the entire ownership period must
now be treated as ordinary income regardless of how long
the property has been owned in either status (1988
Publication 523). If the status of the property is changed
in this way, the taxpayer is treated as voluntarily giving
up rights of capital gain exclusion for the principal
residence. The tax benefits of capital gain nonrecognition
for residence have been forfeited. Since this is
ordinarily disadvantageous, it should only be done after
consideration of potential benefits.
Is The Reverse True?
If the status of the property was changed from rental
property to principal residence and the property was
thereafter sold for a gain and also replaced, can the
taxpayer claim nonrecognition of the gain for the
residence? If so, an owner could reduce taxes by changing
a rental property to a principal residence shortly before
it is about to be sold. The capital gain on the rental
property would be deferred.
As mentioned, for the taxpayer to be able to defer the
capital gain on the sale of a principal residence, there
must be a wait of at least two years from the date of
purchase. The change of status from rental property to
principal residence is considered as a sale of the
property. Thus, the two-year waiting period becomes
mandatory Sec. 1034(d).
If the status of a property has changed from rental
property to principal residence and this residence was
thereafter sold and replaced with a new residence, the
total gain throughout the entire ownership period can be
deferred to serve as a reduction of the cost of the new
residence if the following conditions are met:
1. The owner has resided there for at least two years
since the change of status; and
2. A new residence is purchased within two years after
the sale. If any condition is not met, the entire gain
must be treated as ordinary income. Under any
circumstances, the depreciation previously taken as a
rental property is always subject to recapture.
Example: On January 1, 1987 Mr. Smith purchased a house
for a cost of $100,000. He rented the entire house to a
tenant and took depreciation on the straight-line method
for 27.5 years with $20,000 salvage value for the land. On
January 1, 1988 he terminated the lease with his tenant
and moved in with his family. On January 1, 1990 he sold
this house for a price of $150,000. On February 1, 1990 he
purchased a new residence for a price of $180,000. What is
the taxable capital gain in 1990? And what is the basis of
his new residence?
This house must be treated as a rental property in 1987
and as a principal residence thereafter. The depreciation
taken in 1987 was $2,909 ($100,000-$20,000)/27.5, and no
depreciation thereafter. The basis on January 1, 1990 when
it was sold was $97,091 ($100,000 - $2,909). Therefore,
the total accounting capital gain was $52,909 ($150,000 -
$97,091). However, since Mr. Smith and his family have
been living there for two years since the date of change
of status on January 1, 1988, to the date of sale on
January 1, 1990, and the new house was also purchased
within two years on February 1, 1990, after the date of
sale, this $52,909 capital gain will not be recognized as
ordinary income in 1990. Instead, it will be deferred to
reduce the cost of the new residence. Therefore, the basis
of the new residence on February 1, 1990 is $127,091
($180,000 - $52,909). Had he sold the house on December 1,
1989, the total accounting capital gain of $52,909 would
have been treated as ordinary income in 1989 because it
had been only 23 months after the change of status, which
is less than the required 24 months of waiting period. The
basis of his new residence would have been $180,000.
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