HomeTax Savings for Home Owners in 1998
by Michael W. Licamele III
As predicted in the Mortgage Almanac's winter issue, President Clintonand the Congress have agreed on legislation that gives home owners muchbigger savings on capital gains taxes when they sell their homes. Untilthis year, only home owners 55 years of age or older were eligible for aone-time $125,000 exclusion from capital gains taxes.
Under the new tax laws, the age restriction has been eliminated, thetotal exclusion amount has been increased and the exclusion can be usedevery time a home is sold (with some restrictions). Also, a home selleris no longer required to purchase a new home in order to shield capitalgains from the sale of a residence but can instead take advantage of thesubstantial capital gains exclusion.
Prior to the recent changes in the tax law, a home seller was requiredto be 55 years of age or older in order to qualify for a one-time exclusionof $125,000 in capital gains from taxes. Many home owners waited to selltheir homes even though they wanted to move in order to guarantee gettingthe tax savings. The old tax law was a clear cut example of home ownerschanging their economic and lifestyle decisions solely for tax purposes.With the new law, all age restrictions have been eliminated and home ownersare free to make decisions without a primary emphasis on the tax consequences.
The new tax law makes the capital gains exclusion available as many timesas a tax payer sells their primary residence. Unlike the old tax law, wheresellers could only use this benefit once, the new laws allow a nearly unlimitednumber of exclusions as long as sellers satisfy three tests. First, sellersmust have owned the residence for periods aggregating at least 2 years ofthe 3 year period ending on the date of sale. Second, sellers must haveused the property as their primary residence for a period of at least 2of the last 5 years. Finally, a seller can not have utilized the exclusionat any time during the previous 2 years.
As long as home sellers satisfies those three tests, they are eligibleto shield up to $500,000 in gain from the profit of the sale if filing ajoint tax return and up to $250,000 for an individual return. This exclusionwill most likely allow the vast majority of Americans to pay no tax at allwhen selling their home. The formula for determining capital gain on thesale of a home is calculated by taking the selling price of the home andsubtracting all selling costs, capital improvements and the original purchaseprice.
The benefits of the new tax law for sellers get even better. EffectiveMay 7, 1997, the new tax rules reduce the capital gains tax rate from 28%to 20% (10% for tax payers in the 15% tax bracket). This means that evenif home sellers do have a profit above the $500,000, any tax paid will beat the lower 20% rate.
How good is the recent tax law for home sellers? Consider the followingexample. Mr. Smith is 48 years old. He and his wife bought their home 10years ago for $200,000. They made $50,000 in improvements over the years.A Realtor recently informed them that their house was now worth $600,000.Recently, another company offered to buy Mr. Smith's small business fora good price. With their children away at college, the Smiths very muchdesired to move from New England to Florida to enjoy the warmer weather.
The old tax laws presented Mr. Smith and his wife with two problems.First, if they sold their home before either of them turned 55, they wouldnot be able to take advantage of the one-time capital gains exclusion. Second,because any home they would buy in Florida would be much less expensivethan the home they were selling, the rollover exclusion would probably nothelp them. For the Smiths to pursue their personal goals, they would besubject to paying taxes on their profits of $350,000 ($600,000 sale priceless $250,000 in acquisition costs plus improvements) at the rate of 28%,resulting in taxes of $98,000. If their home in Florida cost less than $250,000(which it most likely would), they would be forced to pay the entire $98,000when they sell their home. Their only alternative would be to wait 7 yearsuntil they reach 55, at which time their tax bill would still be $63,000.
The new tax law was designed to help home owners exactly like the Smiths.As of May 7 of this year, the Smiths may now sell their home and pay notax on their $350,000 in capital gains. They will save $98,000 and willnot be required to wait until a certain age. Needless to say, the recenttax changes are victory for home owners.
As with any tax change, there are some good and bad parts that are buriedin the details. The Treasury department is creating regulations to provideexceptions to the rule requiring 2 years of ownership and residence in casesof illness, employment transfers or other "unforeseen circumstances."Also, the $250,000 exclusion per single tax payer could actually be a benefit.For example, if 3 brothers own a home together they could shield up to $750,000in gain from the sale of a home. Many other parts of the new tax law willcreate opportunities for astute tax planners.
On the negative side, losses on the sale of personal residences are stillnot deductible. This amendment did not become part of the final law. Whilefew home owners need to worry about losses in today's booming real estatemarket, it was only a short time ago in the 1989-1992 period when many homeowners were forced to take substantial losses on their homes. Another negativeis that owners of rental property and home owners who take home office deductionswill find their tax calculations extremely complicated with the new rules.
Unlike many tax law changes, policy makers are uncertain as to the neteffect of the new rules for home sellers. On the one hand, increasing theexclusion on capital gains to $500,000 for married couples filing jointlyfor home sales means that most home sellers will not pay any capital gainstaxes. This would appear to reduce tax revenues. On the other hand, thewealthy will no longer be able to rollover capital gains as long as theybuy a home of equal or greater price. Thus, home sellers with million dollaror more gains will be forced to pay 20% capital gains tax on all amountsexceeding $500,000. In addition, most home owners waited until age 55 tosell their home anyway, meaning they would not have paid taxes on up to$125,000 in capital gains.
The new tax law will most likely have a greater impact on the overalleconomy. When home owners do not sell their homes because they are waitingfor age 55, new home buyers do not buy those homes and spend funds to remodel,furnish and decorate. The more homes that are sold to new home buyers, themore the economy will be stimulated by consumer demand for these items.The actual impact of the new laws, of course, remains to be seen.
Whatever the effect on the overall economy, there is no doubt that mosthome owners won a great victory with the most recent changes to the taxcode.