Copyright© 2008
CALIFORNIA ASSOCIATION OF REALTORS® (C.A.R.). Permission
is granted to C.A.R. members only to reprint and use
this material for non-commercial purposes provided
credit is given to the C.A.R.Legal Department. Other
reproduction or use is strictly prohibited without the
express written permission of the C.A.R. Legal
Department. All rights reserved.
Table of
Contents
I.
Taxation on Sale of Principal
Residence (Questions 1 -
19)
II. Capital Gains Tax (Questions 20 - 27)
Introduction
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. The Mortgage Forgiveness Debt Relief
Act of 2007 (the "2007 Act") also provides clarification
regarding certain capital gains
issues.
Additionally, the Jobs and
Growth Tax Relief Reconciliation Act of 2003 (the "2003
Act") made important changes to the federal
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. Sunset
provisions in the 2003 Act were extended by the Tax
Increase Prevention and Reconciliation Act of 2005 (the
"2005 Act").
Recently, with the passage of H.R. 3221, the
Housing and Economic Recovery Act of 2008, further
changes were made to capital gains exclusions for a
principal residence that wasn't used as a principal
residence part of the time of
ownership.
This legal article discusses
portions of all of these laws having an impact on
capital gains treatment for the sale of real property
and providing an exclusion from income for gain from the
sale of a principal residence. This article
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.
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I. Taxation on 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 (26 U.S.C. § 121 also cited
as IRC § 121).
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. (IRC § 121.)
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 § 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 (IRC § 121).
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.
(IRC § 121.)
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.
(IRC § 121.)
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. (IRC §
121.)
Q
8. If my
spouse dies, must I sell our principal residence within
the year of my spouse's death in order to take advantage
of the $500,000 exclusion from gain?
A No.
The 2007 Act amends IRC § 121(b) to allow the exclusion
of $500,000 in capital gains tax if the principal
residence is sold within two years of the spouse's death
(but this applies only for sales after December 31,
2007).
Q
9. 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
10. 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
1.121-3(b) 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 11 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 11 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 11 for a definition
of qualified individual.)
(26
C.F.R. § 1.121-3.)
Q 11.
Who is a "qualified individual" as used in Question
10?
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 § 152(a)(1) through (8), without regard to
whether they are actually a dependent, or (ii) a
descendent of the taxpayer's
grandparent. (26 C.F.R. § 1.121-3(f).)
Q 12.
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.
(26 C.F.R. §
1.121-3(b).)
Q 13.
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 14.
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 15.
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 16.
What happens if I transfer my principal residence
into a revocable living trust?
A IRC §
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 17. May I
utilize an IRC 1031
("like kind" tax-deferred 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 was
no longer possible. Pursuant to the American Jobs
Creation Act of 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.
Q 18. Is the
exclusion treated differently for the sale of a
principal residence that was used as a second home or as
income property during the ownership
period?
A Yes. For any
periods of ownership occurring on or after January 1,
2009, under the Housing and Economic Recovery Act of
2008 (H.R. 3221), the exclusion from capital gains
recognition will be reduced by the amount of time the
property was not used as a principal residence (“non
qualified use”). The gain from the sale will be
allocated between periods when the property was used as
a principal residence (“qualified use”) and periods of
non-qualified use. The math is as follows:
The gain is multiplied by a fraction where the top
number (the numerator) is the period that the property
was used as a principal residence (qualified use) and
the lower number (the denominator) is the total period
of ownership.
Gain x (Time of qualified
use/Total time
owned) = exclusion
from capital gains (capped at $250,000
and $500,000).
Example: A married
couple filing jointly purchased a vacation property on
January 2, 2009 which they sell on January 2, 2017 for a
gain of $600,000. During the last two years of
ownership they occupied the property as their principal
residence. They would multiply $600,000 gain by 2
years of qualified use divided by 8 total years of
ownership (or $600,000 x ¼ = $150,000). They could
exclude $150,000 from capital gains (which is less than
the $500,000 cap for joint filers) and the balance of
the $600,000 gain, $450,000 would be taxed as capital
gains.
Q 19. Are there
exemptions from the non qualified use
rules?
A Yes. There are three
exemptions from the non qualified use rules:
1) Any
portion of the 5-year ownership and use requirement
occurring after the last date the property was used as a
primary residence of the taxpayer or the taxpayer’s
spouse.
Some examples may help.
Example One:
In January 2009, married taxpayers
filing a joint return buy a house and use it as their
principal residence for the first two years. They then
convert the residence to a rental for the next three
years, after which they sell the residence and realize
gain of $600,000. None of the three years of
otherwise non qualified use after the initial use as a
principal residence would be used to reduce the
capital gains exclusion. They would be entitled
to the full $500,000 exclusion and would owe capital
gains on $100,000.
The formula would be the $600,000 gain
times the five years of qualified use (the initial
two-year qualifying use period plus the balance of the
five-year qualifying ownership period following the
two-year qualifying use period) over the five year
total ownership period.
$600,000 x
5/5 = $600,000
qualifying gain (capped at $500,000 for joint
filers).
Example Two:
The same couple buys a house in
January 2009 and rents it out for the first three
years. They then convert it to their principal
residence for the next two years. Following this
they once again rent the residence out, this time for
three years, after which they sell the residence for
$600,000 gain. They owned the property for a total of
eight years. They have three years of non
qualified use and five years of qualified use (the
two-year qualifying use period plus the balance of the
five-year qualifying ownership following the two-year
qualifying use period).
The formula would be $600,000 gain
times five years of qualified use over eight total
years of ownership.
$600,000 x
5/8 = $375,000
excluded from capital gains and capital gains tax
would be owed on $225,000.
Example Three:
The same couple buys a house in
January 2009 and rents it out for six years.
They then occupy it as their principal residence for
two years and sell it for $600,000 gain. Since
none of the five-year qualifying ownership period
occurs after the two-year qualifying use period only
the last two years of occupancy count as qualified
use.
The formula would be $600,000 times 2
years of qualified use over 8 total years of
ownership.
$600,000 x
2/8 [or 1/4] =
$240,000 excluded from gain and capital gains tax
would be owed on $360,000.
The other two exemptions from the non-qualified
use rules are:
2) Any
period (not to exceed an aggregate period of 10 years)
during which the taxpayer or taxpayer’s spouse is
serving on extended official duty as a member of the
Foreign Service or the uniformed services of the United
States, and
3) Any
other period of temporary absence (not to exceed an
aggregate of two years) due to change of employment,
health conditions, or other such unforeseen
circumstances.
For more
examples of calculating capital gains exclusions visit
N.A.R.’s website at http://www.realtor.org/gapublic.nsf/pages/hr_3221_key_provisions.
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II. Capital Gains
Tax
Q 20.
What are the basic capital gains tax
rates?
A The 2003
Act reduced 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 were reduced to 5 percent.
Q 21.
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 22.
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
23. When did 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.
Q
24. Do these capital
gains rates expire?
A
Unless the U.S. Congress extends them, under Section 102
of the 2007 Act the capital gains rate reductions will
sunset December 31, 2010, at which time the rates will
revert to 20 percent and 10 percent.
Q 25.
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 26.
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
and zero percent beginning in 2008). The
capital gains rate reverts to 20 and 10 percent for
assets held for more than 12 months and sold after
December 31, 2010.
Q 27.
Can I still take advantage of an IRC 1031 ("like
kind" tax-deferred) exchange?
A Yes.
The tax-free exchange of "like-kind" property used
in a trade or business is not affected by the 1997,
1998, 2003 or 2007 Acts.
Q
28. Where can I obtain
additional information?
A This legal
article is just one of the many legal publications
and services offered by C.A.R. to its members.
Readers who require specific advice
should consult an attorney.
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