Tax Planning for Capital Gains and Residence Sales

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, December 21, 1997

Copyright © 1995-2004 Robert L. Sommers, all rights reserved.


The Taxpayers Relief Act of 1997 has reduced the capital gains tax from 28% to 20% for assets sold after May 6, 1997, and held longer than 18 months. These rules, however, do not apply to collectibles such as artwork, trading cards, stamp collections and memorabilia.  See the accompanying chart.

Technical corrections legislation is pending (H.R. 2645) which provides the "netting" order for gains and losses from each of the new tax-rate groups. A taxpayer’s long-term (12-month-plus holding period) gains and losses are separated into the following three tax groups: 28%; 25% and 20% (10% group for those in the 15% bracket). Within each group, capital gains and losses are netted, thereby producing either a gain or loss for the group.

As under prior law, short-term (less than 12-month holding period) gains and losses (including loss carryforwards) are netted. If a net short-term capital loss results, then this loss reduces long-term capital gains in the following order: the 28% group, the 25% group and, finally, the 20% group.

A net loss from the 28% group (including long-term capital loss carryovers) is used to reduce gain from the 25% group, then the 20% group. Losses from the 20% group first offset gains from the 28% group and then the 25% group. If, after application of these netting rules there is a net gain, the gain is taxed at the group’s marginal tax rate (28%, 25% or 20%).

Example: In 1997, you have a short-term gain of $200 and a short-term loss of $400, creating a net short-term loss of $200. Assume you had a $25 gain in the 28% group, a $100 gain in the 25% group and a $300 gain in the 20% group. The short-term capital loss would be first applied to the $25 net gain in the 28% group ($200 loss - $25 gain = $175 loss). The balance of $175 is applied to the 25% group ($175 loss - $100 gain = $75 loss) and, finally, the 20% group ($300 gain - $75 loss = $225 net gain in the 20% group). You pay 20% tax on $225 of gain.

Taxpayers are eligible for these new rates when they receive payments of principal under an installment sale, even though the asset was sold prior to the effective date.


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). The new exclusion applies to one home sale per two-year period, for sales occurring after the effective date.

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%.

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) 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.

Suppose a single man sells his principal residence on October 1, 1997, for a $500,000 profit. He meets the ownership and use test, and his girlfriend also meets the use test. If they get married by midnight December 31, 1997, they are eligible to file a joint return for 1997 and, therefore, he may exclude the entire $500,000 of profit.

The two-year period begins when a person acquires the principal residence by purchase, gift or inheritance. If the new residence was acquired in a transaction in which gain was not recognized under former IRC Section 1034 (a tax-free rollover of a principal residence), taxpayers may include periods of ownership and use of those residences, provided the previous gain was rolled over (under Section 1034) into the current residence.

Divorced taxpayers may tack on the ownership and use of their residence by their former spouse. Widowed taxpayers may tack on the ownership and use by their deceased spouse. For those living in a nursing home, the ownership and use test is lowered to 1 out of 5 years. And time spent in the nursing home still counts toward ownership time and use of the residence.

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. Under the technical corrections bill, taxpayers apply the fully exclusion ($250,000 or $500,000) to the percentage of use which is determined by the months of use prior to sale, divided by 24.

Example: If a taxpayer eligible for a $250,000 exclusion meets the ownership and use test for 12 months then sells his home for $100,000 profit, the entire amount would be excluded (12/24 X $250,000 = $125,000 maximum available exclusion).

Those with huge gains should consider converting a portion of their home to legitimate investment property or having their children meet the ownership and use tests.

For example, a married taxpayer residence has a potential gain of $750,000. By converting 1/3 to investment property, then selling the 2/3 residential portion for $500,000 and using the Section 1031 tax-free exchange provisions for the 1/3 investment portion, the entire transaction becomes tax-free (Note: Sec. 1031 has stringent requirements).

For example, if a married couple owns a residence together with their adult son who meets the ownership and use tests as to 1/3 of the property, the son may sell his share for $250,000 gain without incurring a tax. His parents could then sell their share for $500,000 without tax, thereby sheltering the entire $750,000 gain.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**