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If you sell your home, apartment or duplex, for a profit, don't jump too quickly to the conclusion that you'll be taxed for your gains. You might be surprised to find otherwise. Also, some of those out-of-pocket fees you paid in the process of selling your property will work to your financial advantage.
This is the good news: You won't be taxed or even required to report the sale of your home unless your gain is more than $250,000 ($500,000 if married filing a joint return). This is called the exclusion rule, and it applies only if you've owned the home for at least two of the last five years leading up to the sale, and lived in the house as your main home for at least two of the last five years.
It's not the amount of money you receive for the sale of your home that determines whether you'll have to include any proceeds as taxable income, but the amount of gain on the sale over your cost, or basis.
If you can exclude all of the gain, you won't need to report the sale on your tax return. (You will likely receive a notice from the IRS requesting information to show your entitlement to the exclusion.) Generally, you may claim this exclusion only once in any two-year period.
If you sell your home for a profit in excess of the $250,000 limit ($500,000 if married filing a joint return), the additional amount is taxed as long-term capital gain.
Exceptions to the Rules
Even if you don't meet the two-year rules (they're called "ownership" and "use" tests), the IRS says there are some cases in which it will make exceptions and all the exclusion. But, the maximum amount you can exclude will be reduced.
For example, the IRS says it will allow a reduced exclusion if you did not meet the "ownership" and "use" tests on a home you sold due to health reasons, a change in place of employment, or an "unforeseen circumstance."
Also, the IRS says that if you did not live in your home the required two years during the five-year period and are a member of the uniformed services or Foreign Service, it may still make an exception and grant an exclusion.
If you realize a loss on the sale of your home, the loss is not deductible. And if your home is sold in a bank foreclosure or repossession, that's treated the same as a sale, meaning you, as the borrower/seller, may realize gain or loss.
Related Tax Deductions
The "points" you paid to get the loan on the house you're selling are generally deductible the year you paid them. But if you haven't deducted all the points you paid to secure a mortgage on the home, you may be able to deduct the remaining points in the year of sale. One example is if you were deducting points paid on a loan on the home you're selling over the life of the loan, you may be able to deduct any points you hadn't deducted in prior years. ("Points" includes loan placement fees, and are also called loan origination fees, maximum loan charges, loan discount or discount points.)
If you're buying another home and took out a new loan, you'll be able to deduct points (and interest) on your new loan, any remaining points left on the old home, and the real Estate taxes paid on both homes. Real Estate taxes are usually divided so that the seller and buyer each pay taxes for the part of the property tax year that each owned the home.
Though they may not be taken as tax deductions on your return, your selling expenses -- such as commissions, advertising fees and legal fees, and even points, can be used to reduce the gain on the home you're selling.
Tax Treatment of Gain from Sale of a House
FINE PRINT IN GAINS TAX EXCLUSION - By Jay Romano
(reprinted from the 01/22/98 issue of the New York Times)
LAST year, the Federal Government gave an extraordinary gift to most homeowners by excluding from taxation as much as $500,000 in gain on the sale of a principal residence.
But that does not mean that everyone who sells a home at a profit will get a half-million dollar tax-free ride. In fact, tax experts say, factors such as marital status, the date of the sale, the present or former use of the property and even the state where the property is located (New Jersey taxes such gains) could have an impact on the tax that sellers will ultimately pay - or not pay - when selling their residence.
"While most homeowners will benefit front the new tax law, many may still find themselves in a taxable situation when they sell their home, ' said Abe Kleiman, a Manhattan certified public accountant.
The most significant limiting factor of the new law Mr. Kleiman said, has to do with the marital status of the owners. Generally, he said, married couples who file jointly can exclude up to $500,000 in gain from taxable income - even if the home is in the name of only one of the individuals. Single taxpayers, Mr. Kleiman said, are allowed to exclude up to $250,000 in gain. Married taxpayers who file individually - in order, for example, to have the ability to deduct medical expenses incurred by a spouse with a minimal income - are also allowed exclusions of $250,000 each, said Mr. Kleiman. One limitation of the new law, he said, is that it eliminates a rather generous element of the old one.
The two-year rollover provision is gone," Mr. Kleiman said, referring to a portion of the old law that allowed sellers to defer paying capital gains taxes on the sale of a principal residence if they invested the proceeds in a replacement dwelling of equal or greater value within two years.
Under the new law, however, any gain in excess of the applicable exclusion may be Subject to tax.
"It's probably not so difficult to imagine older people who have a home worth $700,000 or $800,000 today, to have a cost basis of $50,000 or $100,000 if they bought their first home 40 years ago," he said. In such situations he added, couples will likely find that they are subject to taxation on any gain that exceeds $500,000 - or worse - $250,000 if the seller is an individual.
Moreover, he said, in situations where one spouse dies, and the surviving spouse has been the sole owner of the property, he or she would have to sell the property in the year the spouse died to qualify for the full $500,000 exclusion. Mr. Kleiman said the reason for this is that a joint return can only be filed for a year that both spouses are alive.
Timing is important.
Joel E. Miller, a Queens tax lawyer, said that for a seller to be eligible for the maximum exclusion under the new law, the property must have been sold after May 6, 1997, and must have been owned and occupied as a principal residence for at least two of the five years preceding the sale.
However, Mr. Miller said, taxpayers who sold their home after May 6, but on or before Aug. 5, 1997 - as well as those who sold homes after Aug. 5 under a contract that was binding on that date - can elect to take the exclusion provided under the new law or to roll over their gain into a replacement dwelling within two years of the date of the sale.
Mr. Miller cautioned, however, that homeowners in such a situation should carefully consider the long-term impact of choosing to roll over their gain.
For example, Mr. Miller said, a married couple with a $100,000 cost basis in a home they sold during the "window period" for $700,000 would have a gain of $600,000 - leaving $100,000 subject to taxation after the $500,000 exclusion. If the couple elects to "roll over" the gain into a $700,000 replacement dwelling, the tax on the gain is deferred until the replacement dwelling is sold.
If the replacement dwelling is sold for $800,000, the couple will then be subject to taxation on $200,000 of their $700,000 gain after taking their $500,000 exclusion. On the other hand, Mr. Miller said, if the couple had chosen not to roll over their gain into a replacement dwelling, but instead bit the bullet and paid the tax on the original $100,000 profit, they would have to pay no additional tax on the sale of the replacement dwelling because they would get a new $500,000 exclusion on that sale.
Another factor that may limit a seller's total tax savings has to do with location of the property. While New York and Connecticut generally follow the same capital gains tax rules as the Federal Government, New Jersey, for one state, does not.
According to Dan Emmer, a spokesman for the New Jersey Division of Taxation, property owners who sell their New Jersey residences at a profit have to include their total gain in their New Jersey taxable income, even if is excluded for Federal tax purposes. Mr. Emmer said that he was not aware of any pending or proposed legislation that would change that rule.
He noted that the homeowner can still defer taxes by rolling over the profit into a replacement within two years.
Finally, even the use of a property - both present and former - can have an impact on the tax that may be due upon sale.
Martin Shenkman, a Teaneck, N.J., tax lawyer, said that those who use a portion of their home for business purposes - such as a home office or rental property - must pay tax on the gain attributable to the portion of the home used for business.
For example, Mr Shenkman said, if half of a two-family house is rented out, only the half used as a personal residence is eligible for the capital gains-tax exclusion; the rental portion is not. Accordingly, he said a homeowner with a $100,000 basis in such a house who then sells the house for $300,000 would have to pay tax on $100,000 of the $200,000 gain. The same general result would occur - but in appropriately different proportions - if part of the home is used as a home office.
One common way to avoid such a result, Mr. Shenkman said, is to discontinue the business use for at least two years prior to the sale, thereby making it possible to treat the entire house as a principal residence. In such a situation, he said, the seller must still account for any depreciation deductions "allowed or allowable" on the business portion of the home.
That means that any depreciation deduction that should have been taken for the business use of the property - whether a deduction was actually taken or not - must be used to reduce the cost basis of the property, thereby increasing the gain subject to taxation.
Under the new law, Mr. Shenkman said, depreciation deductions taken before May 7, 1997, are treated as before - as reductions to the basis that increases gain. The increase in gain, however, can be offset by the exclusion available under the new law.
But depreciation deductions taken from May 7 onward cannot be offset by the exclusion, but must be included in taxable income. That means, Mr. Shenkman said, that anyone taking a home-office deduction after May 7 should discuss the matter with his or her tax adviser.
In fact, he said, as generous as the new law seems, it should not lull homeowners into a false sense of security. There is no guarantee, he said, that the $250,000/$500,000 exclusion, which seems like a lot of money now, will be sufficient to cover accrued gains realized 20 or 30 years in the future.
"Every homeowner still has to keep detailed records and crunch the numbers when it comes time to sell," he said.