As predicted in the Mortgage Almanac’s winter issue, President Clinton and the Congress have agreed on legislation that gives home owners much bigger savings on capital gains taxes when they sell their homes.
Until this year, only home owners 55 years of age or older were eligible for a one-time $125,000 exclusion from capital gains taxes.
Under the new tax laws, the age restriction has been eliminated, the total exclusion amount has been increased and the exclusion can be used every time a home is sold (with some restrictions).
Also, a home seller is no longer required to purchase a new home in order to shield capital gains from the sale of a residence but can instead take advantage of the substantial capital gains exclusion.
Prior to the recent changes in the tax law, a home seller was required to be 55 years of age or older in order to qualify for a one-time exclusion of $125,000 in capital gains from taxes. Many home owners waited to sell their homes even though they wanted to move in order to guarantee getting the tax savings. The old tax law was a clear cut example of home owners changing their economic and lifestyle decisions solely for tax purposes.With the new law, all age restrictions have been eliminated and home owners are free to make decisions without a primary emphasis on the tax consequences.
The new tax law makes the capital gains exclusion available as many times as a tax payer sells their primary residence. Unlike the old tax law, where sellers could only use this benefit once, the new laws allow a nearly unlimited number of exclusions as long as sellers satisfy three tests. First, sellers must have owned the residence for periods aggregating at least 2 years of the 3 year period ending on the date of sale. Second, sellers must have used the property as their primary residence for a period of at least 2 of the last 5 years. Finally, a seller can not have utilized the exclusion at any time during the previous 2 years.
As long as home sellers satisfies those three tests, they are eligible to shield up to $500,000 in gain from the profit of the sale if filing a joint tax return and up to $250,000 for an individual return. This exclusion will most likely allow the vast majority of Americans to pay no tax at all when selling their home. The formula for determining capital gain on the sale of a home is calculated by taking the selling price of the home and subtracting all selling costs, capital improvements and the original purchase price.
The benefits of the new tax law for sellers get even better. Effective May 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 even if 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 following example. Mr. Smith is 48 years old. He and his wife bought their home 10 years 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 much desired 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 would not 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 expensive than the home they were selling, the rollover exclusion would probably not help them. For the Smiths to pursue their personal goals, they would be subject 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 $98,000 when they sell their home. Their only alternative would be to wait 7 years until 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 buried in the details. The Treasury department is creating regulations to provide exceptions to the rule requiring 2 years of ownership and residence in cases of 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 $750,000 in gain from the sale of a home. Many other parts of the new tax law will create opportunities for astute tax planners.
On the negative side, losses on the sale of personal residences are still not deductible. This amendment did not become part of the final law. While few home owners need to worry about losses in today’s booming real estate market, 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 negative is that owners of rental property and home owners who take home office deductions will find their tax calculations extremely complicated with the new rules.
Unlike many tax law changes, policy makers are uncertain as to the net effect of the new rules for home sellers. On the one hand, increasing the exclusion on capital gains to $500,000 for married couples filing jointly for home sales means that most home sellers will not pay any capital gains taxes. This would appear to reduce tax revenues. On the other hand, the wealthy will no longer be able to rollover capital gains as long as they buy a home of equal or greater price. Thus, home sellers with million dollar or more gains will be forced to pay 20% capital gains tax on all amounts exceeding $500,000. In addition, most home owners waited until age 55 to sell 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 overall economy. When home owners do not sell their homes because they are waiting for 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, the more 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 most home owners won a great victory with the most recent changes to the tax code.
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