Capital Gains: Taxpayer Relief Act of 1997

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When the 105th Congress passed H.R. 2014, the federal Taxpayer Relief Act of 1997, home owners breathed a sigh of relief, but three years later the sighs more often revealed exasperation over several misunderstood provisions.

The federal tax law says when you sell your home, if you qualify, you can keep, tax free, capital gains of up to $500,000 if you are married filing jointly or $250,000 for single taxpayers, or married taxpayers who file separately.

“The biggest confusion is that many people think that the $500,000 applies to everyone. It only applies to couples who file joint returns. It comes as a big shock that you only get the $250,000 exclusion if you are single or filing separately,” said Leonard L. Williams a Sunnyvale, CA certified public accountant.

Under the law, to qualify for the $500,000/$250,000 exclusion, the home must have been your primary residence for at least two of the prior five years.

That has two implications.

Residency, use requirements

First, the two-year primary-residence-use requirement doesn’t mean you must physically occupy your home every day for 720 days.

If you are away on a business trip or on an around the world cruise for several months, or otherwise not physically living in your primary residence for relatively short periods, that doesn’t interrupt you from meeting the two year requirement.

Capital gains tax relief extended to home offices

When the Internal Revenue Service published guidance about capital gains tax exclusions on the sale of your home, giving millions of home sellers an early Christmas present, it also sent a little package of cheer to home-based business owners who sell their home.

As long as your qualified home-based business is in the same dwelling as your primary residence — rather than some unattached structure on your property — you don’t have to allocate a home sale’s capital gains between the home and the business, according to “Exclusion Of Gain From Sale Or Exchange Of A Principal Residence,” U.S. Department of Treasure Decision 9030, published Dec. 24, 2002 in the Federal Register, Vol. 67, No. 247.

The provision is among the latest round of Congressional tinkering with the Taxpayer Relief Act of 1997. Law makers have been adjusting the landmark tax package since it was enacted more than a half decade ago.

( Also see: “A dozen tax breaks, on the house”

Among numerous provisions, home sellers have most enjoyed the provision that says when you sell your home, up to $500,000 of capital gains is excluded from federal taxes for married couples who file a joint tax return. Up to $250,000 is excluded for those filing separate or single-filer returns. To qualify for the exclusion when you sell your home, you must have lived in your home as your primary residence for two of the past five years.

The tax relief law, which applies to sales made after May 6, 1997, also said if you qualify for and take the home-office deduction, that portion of your home designated as a work place was not eligible for the exclusion.

“If you used 10 percent of your home for a home-based business, 10 percent of the gain on the sale would be subject to capital gain taxes and you couldn’t use the exclusion on that portion,” said Marie Sternberger, an enrolled agent from Sunnyvale, CA.

That forced some home-based business owners to forego the home-based business deductions for two years in order to maintain the two-out-of-five primary residency requirements for the full capital gains tax exclusion.

How the law changed

That’s no longer necessary.

Provided you meet the primary residency and other requirements, even if you operate a business from your home, you are entitled to the full tax exclusion on capital gains realized from the sale of your home, according to “IRS Issues Home Sale Exclusion Rules”.

What’s more, if you sold your home and were not able to take full advantage of the $500,000/$250,000 capital gains tax exclusion you can amend your tax return to do so. If you’ve already taken full advantage of the exclusion, it’s not necessary to file an amended return.

There is a three-year statue of limitations on the amended return, meaning you likely can amend only the 1999, 2000 or 2001 returns.

“It’s three years from the later of the due date of the return, including any extensions, or the date you actually filed,” said Marie Sternberger, an enrolled agent in Sunnyvale, CA.

Don’t forget, the Taxpayer Relief Act still requires that if you sell your home and you’ve taken a depreciation deduction, you still must recapture (or pay back) that depreciation at the rate of 25 percent. That’s hasn’t changed.

“It’s (the new rule for home-based businesses) still a good deal, if you think about your tax reduction,” said Sternberger.

Home-based business deductions (office, payroll, labor, auto, travel and entertainment expenses, business asset depreciation, supplies, items purchased for resale, etc.) reduce your net profit which in turn reduces your self-employment taxes and your income taxes.

“The home-office related tax reduction you are getting exceeds the 25 percent recapture amount,” said Sternberger.

“So long as the home is still your primary residence, being away doesn’t take away from counting toward the two years,” says personal finance advisor Eric Tyson, author of “Personal Finance for Dummies” (IDG Books, $19.99).

If you’ve met the two year requirement and for whatever reason must leave it vacant for extended periods, to retain the exclusion you’ll have to sell it within the allotted five year period, or after five years are up, move back in to reestablish the two year requirement.

“The fact that you may be away from it for up to three of the last five years is the only allowance that the Internal Revenue Code gives you for temporary absences,” said Williams.

Second, rental homes

In another twist, if you have a second home where you live, go to work, send the kids to school or otherwise treat as your primary residence, say every other year, it will take you four years to qualify either or both homes.

“Theoretically, you have qualified both homes to exclude taxes on the gain, but you can only take one and wait another two years before you can take the other,” said Marie Sternberger, an enrolled agent in Sunnyvale, CA.

The liberal law not only says you can take the exclusion on one home every two years, it also says you can take it as often as you meet the qualifications.

“That makes the law a good tax planning tool,” says Sternberger. For example, if you have a rental property you move into after selling your first home and taking the exclusion, two years later, you can also exclude taxes on the gain from the rental-turned-primary residence. You’ll have to recapture any depreciation (depreciation is taxed at a federal tax rate of 25 percent) on the rental.

Two-year requirement loophole

A related law also makes provisions for you if, through some unforeseen event, such as a job change, illness or some other hardship, you are forced to sell before you meet the two-year residency requirement.

The federal Internal Revenue Service Restructuring and Reform Act of 1998 says you can prorate the $500,000/$250,000 exclusion (not your specific gain) if you are forced to sell early.

That means if you only live in your home a year before you are forced to sell, you can exclude from taxes up to $250,000 in capital gains if you are married and file jointly or $125,000 for separate and single filers.

Old laws erased, not deferred gain

Finally, the tax relief act also removed from the books the $125,000 tax exclusion on capital gains for home owners older than 55 and the “rollover” law that allowed you to defer paying your taxes provided you purchased another, more expensive home. Those laws are history.

However, any capital gain taxes deferred before the tax relief act are unpaid taxes that must be accounted for.

“Previously deferred gain reduces the cost basis on your next home. If you have a deferred gain of $100,000 and buy a home for $250,000 your cost basis (against which you will figure capital gains when you sell it) is $150,000,” said Sternberger.

‘Unforeseen circumstances’ better defined

More than half a decade after U.S. Congress passed the federal Taxpayer Relief Act of 1997, the Internal Revenue Service was still tinkering with its provisions.

One adjustment, which, clarifies how to define the nagging “unforeseen circumstances” provision, warrants a reexamination of the tax relief act to fully understand the adjustment’s significance.

The Taxpayer Relief Act of 1997 is the federal tax law that says when you sell your home you can keep, tax free, capital gains — profits — of up to $500,000 if you are married filing jointly. The tax exclusion is on capital gains of up to $250,000 for single taxpayers or married taxpayers who file separately.

The exclusion is available when you sell your home if the property has been your primary residence for at least two years during a five-year period ending on the date of the sale.

The new law did away with two previous capital gains tax laws.

“There’s no longer any such thing as a tax deferral through the sale and replacement of a personal residence (known as the capital gains “rollover” law), and hasn’t been since 1997. Many people still haven’t gotten this message,” said Leonard W. Williams, a certified public accountant in Sunnyvale.

Along with removing the “rollover” provision, the tax relief act also removed from the books the $125,000 tax exclusion on capital gains for home owners older than 55.

The current Taxpayer Relief Act of 1997 does provide for a prorated exclusion available because of unexpected job changes, health problems or other “unforeseen circumstances” that force you to sell your home before you reach the two-year milestone.

The amount prorated is the exclusion, not the specific gain. For example, if you only live in your home for year before you are forced to sell, you can exclude from taxes up to $250,000 in capital gains if you are married and file jointly; $125,000 for separate and single filers.

However, what specifically constituted an “unforeseen circumstances” was left to the interpretation of tax payers, tax professionals and even the IRS.

The latest adjustment better defines “unforeseen circumstances” by addressing how to define it.
“The final regulations narrow the definition (of ‘unforeseen circumstances’) from ‘an event that the taxpayer did not anticipate’ to ‘an event that the taxpayer could not have reasonably anticipated’ prior to purchasing and occupying the residence,” said Marie Sternberger, an enrolled agent from Sunnyvale who specializes in taxation matters.

“The final regulations did not include marriage or the adoption of a family member as additional unforeseen circumstances because, according to IRS, marriage and adoption are voluntary events that are not unforeseeable,” Sternberger added.

Likewise a sale that is only beneficial to the general health or well-being of the home owner won’t qualify for the tax break.

The new rules still allow taxpayers to make a case for “unforeseen circumstances,” but also gives specific guidelines for acceptable incidents of “unforeseen circumstances,” including:

• The “involuntary conversion” of your home, say, when the state government or other eminent domain order requires you to sell your house to make way for a new highway.

• Natural or man-made disasters or acts of war or terror that damage the residence.

• The death of the homeowner, a spouse, co-owner or other person whose principal place of residence is the house that was sold.

• Health problems, if the primary reason for the sale is “to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury” of the home owner, co-owner, spouse or other resident.

• A loss of employment triggering eligibility for unemployment compensation.

• A change in employment status that results in the owner’s inability to pay housing costs and reasonable basic living expenses.

• Divorce or legal separation.

• Multiple births resulting from the same pregnancy.

Also military personnel posted abroad for extended periods can now stop the clock on the two-of-the-past-five-years provision until they return stateside.

“It seems to me that IRS is tightening the ‘unforeseen circumstances’ provision and making it harder to qualify under these regulations,” said Sternberger.

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