Frequently Asked Tax Questions --February 23, 1997

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, February 23, 1997

 

Clinton's tax proposal for residence; passive activity loss rules

ROBERT L. SOMMERS

Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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Clinton's tax proposal for residence; passive activity loss rules


Questions

  1. Question: I am concerned about Clinton's recent tax proposal concerning the sale of a principal residence. I am over 55 with a home worth $1.1 million that I bought for $100,000. What happens if I sell it to buy a home worth only $1M?

    [Answer]

  2. Question: Because of recent salary raises, I can no longer currently deduct any losses from my rental property. What happens to these losses and when will I be able to claim them?

    [Answer]



  1. Answer to Question #1:

    President Clinton's current proposal for sales of principal residences (now winding its way through Congress without serious opposition) will exclude the first $500,000 of gain from taxation. This sounds great for those Californians who want to downsize (move less expensive home without incurring any tax). Californians could sell their homes, exclude $500,000 of gain and happily retire in the great Northwest.

    Unfortunately, those large capital gains might get the shaft. The proposal will eliminate two key provisions in the current law: (1) the current rollover provision which eliminated any capital gain if, in general, you acquired a replacement residence of equal or greater value, within 24 months from the sale of your old residence; and (2) the once-in-a-lifetime election for those age 55 or older which permits you to exclude up to $125,000 of gain on your home.

    Under current law, you could exercise your once-in-a-lifetime election to exclude $100,000 of your gain and use the rollover provisions to purchase a replacement home at no tax cost. Under Clinton's proposal, you'll have a $1M gain minus a $500,000 exclusion and, consequently, a capital gain of $500,000. Using a combined federal and California tax rate of 33%, your income tax liability will now be $167,000.

    This tax proposal could be devastating for those with large potential capital gains who plan to acquire a similarly priced home for retirement. In your case, you'll have $933,000 after the tax is paid ($1.1 million sales price less $167,000 in taxes) -- not enough to purchase the $1 million replacement home. Of course, this new law will adversely affect your ability to sell your house, since buyers cannot use the rollover provisions to acquire it (although they can use the $500,000 exclusion) and will probably impact the seller of your new replacement home, because you'll have less money to purchase it. The added tax cost should cause a price decline in the market for expensive homes, thereby harming major segments of the real estate industry.

    Another hidden cost in this proposal is the effect on property taxes under Proposition 13. If housing values in wealthy communities drop in proportion to the new tax cost (assume roughly 15-25%), then recent home purchasers will have a strong argument for a downward adjustment on their property taxes, since the value of their homes would have suddenly decreased.

    The Clinton proposal would be fairer if taxpayers could choose either the new $500,000 exclusion or current rollover provision.

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  2. Answer to Question #2:

    Your recent success in the workplace has triggered the "passive activity loss" limitations for owners of real estate. Under current law, those who "actively participate" (making management decisions such as the amount of lease rent or arranging for upkeep) in real estate may deduct up to $25,000 in annual losses against their income. Unfortunately, once a person's adjusted gross income (AGI) reaches $150,000, then none of the losses are currently deductible. The $25,000 deduction is phased out at the rate of $1 for every $2 of AGI over $100,000. For instance, if your AGI is $130,000, then you are entitled to $10,000 of losses ($30,000 of additional AGI reduces your $25,000 deduction by $15,000).

    Suspended losses are carried forward and are used to off-set additional income from the property or may be reinstated if the taxpayer's AGI falls below the $150,000 ceiling. Generally, once there is a disposition of the entire activity, such as a sale of the only rental property you own, then the suspended losses may be used in full. With multiple properties, certain elections must be made with respect to the disposition of the entire passive activity. The passive activity loss rules are enormously complicated and expert advice is necessary for those who own multiple properties or who have partial interests in property through partnerships, corporations or limited liability companies.

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