Navigating the Capital Gains and Sale of Residence Labyrinth

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, August 31, 1997

Copyright 1997 Robert L. Sommers, all rights reserved.

Navigating the Capital Gains and Sale of Residence Labyrinth

Of all the changes in the new tax law, the rules regarding principal residences and capital gains have sparked the most interest. Here are the details on these provisions.

Sales of a Principal Residence: If you sell your residence after May 6, 1997, you may exclude up to $250,000 of your capital gain provided you have owned and lived in your residence an aggregate of at least 2 of 5 years prior to sale (the "ownership" and "use" test). You may tack on ownership and use of a prior residence, as long as you rolled over the gain from the sale of your prior residence to your current residence under prior law (Section 1034). The new exclusion applies to one home sale per two-year period.

The previous Section 1034 rules and the once-in-a-lifetime exclusion of $125,000 are repealed, although those who sold their homes, or acquired replacement homes, prior to August 5, 1997, may apply those rules.

Married couples filing jointly may exclude up to $500,000 in gain, provided: (1) either spouse owned the residence; (2) both spouses meet the use test; and (3) and neither spouse has sold a residence within the last two years.

If a married couple each owns and occupies a separate residence and files jointly, each may exclude up to $250,000 in gain. Also, if it’s a new marriage and one spouse sold a residence within 2 years before the marriage, the other spouse may exclude up to $250,000 in gain on a residence owned prior to the marriage.

The exclusion does not apply to depreciation allowable on residences after May 6, 1997. Therefore, taxpayers should reconsider using a portion of their homes as offices, since the depreciation will be taxed at 25%.

A partial exclusion is available if a residence is sold prior to the two-year-use requirement, because of a change in employment, health or unforeseen circumstances. Generally, it is a percentage determined by the months of use prior to sale, divided by 24.

Example: If a taxpayer sells a house for $50,000 and met 12 months of the use test, then $25,000 would be excluded ($50,000 X 12/24 = $25,000).

For those living in a nursing home, the ownership and use test is lowered to 1 out of 5 years prior to entering a facility. Time spent in the nursing home still counts toward ownership time and use of the residence. For example, if a taxpayer owns and lives in a home for 1 year, resides in a nursing home for 10 years, then sells the residence, the exclusion will apply.

Capital Gains: In general, the maximum capital gains rate is 20% (10% for those in a 15% tax bracket) for sales by individuals, trusts and estates of long-term capital gains after May 6, 1997 ("new rates"). Under prior law, the maximum tax was 28% and 15% for those in the 15% tax bracket ("old rates").

According to the legislative history, these new rates apply to installment payments received after May 6, 1997. For assets sold between May 7th and June 28th, the holding period is 12 months. After June 28, 1997, the holding period is 18 months.

The holding period begins the day after an asset is acquired and ends on the date of sale. The number of months is determined by using the same day in each month that the holding period began. For example, an asset purchased on August 14, 1997, has an initial holding period of August 15th and a new month begins on the 15th day of each subsequent month. Therefore, the 18-month holding period is reached on February 15, 1999.

Real estate depreciation is taxed at 25% to the extent of the depreciation allowed or allowable (Remember: Depreciation occurs whether or not the taxpayer deducts it on a tax return).

Example: A building is purchased for $500,000, has $100,000 of depreciation and $50,000 of improvements. Therefore, the adjusted basis is $450,000 ($500,000 cost, minus $100,000 of depreciation, plus $50,000 of improvements). If the building is sold for $750,000 10 years later, the gain is $300,000 ($750,000 minus $450,000). The gain is taxed as follows: $100,000 of depreciation at 25% = $25,000, plus $200,000 at 20% = $40,000, for a total tax of $65,000.

Collectibles (stamps, baseball cards, automobiles, antiques, paintings, gems and most coins) are taxed at old rates. However, certain gold and silver coins issued by the federal government and coins issued under state law qualify for new rates.

Small business stock (certain stock held for 5 years in a small business) that qualifies for the 50% exclusion is not eligible for the new rates. But if the stock is sold between 18 and 60 months, and thus is ineligible for the 50% exclusion, then the new rates will apply.

Assets must be held for at least 18 months for the new rates. Assets held between 12 and 18 months are taxed at the old rates. Assets held less than 12 months are short-term capital gains and, in general, are taxed as ordinary income.

After December 31, 2000, the new rates are lowered to 18% (8% for those in the 15 percent bracket) for assets held more than 5 years ("lower rates"). For those in the 15% bracket, assets held prior to January 1, 2001, are eligible for lower rates, provided they are held an additional 5 years.

To qualify for lower rates, those in higher brackets must acquire the asset after December 31, 2000, and hold it for 5 years. Taxpayers may apply these lower rates to assets held on December 31, 2000, by electing to treat the asset as sold on January 2, 2001, for its fair market value and paying the tax on the gain. Under this election, the 5-year holding period would begin on January 2, 2001. In general, taxpayers will not elect to pay an immediate tax unless the gain was negligible. Taxpayers cannot recognize a loss under these rules.


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