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Real Estate Matters

By Terry Farrell

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

HOME SELLERS' TAX LAW

The 1997 Tax Law for Home Sellers was approved by Congress on May 7, 1997, and signed by the President on 8/5/97.

There's lots of fine print and complexity. Make sure you discuss the particulars with your tax adviser before acting on this information.

HOME SELLER TAX RULES

It's easy. No more rollover, no more over-55 rule (with its once in a lifetime and tainted spouse limitations).

Effective May 7, 1997, if you meet 3 tests, you qualify:

1. "USE TEST:" Did you live in your principal residence for any 2 year total period within the last 5 years?
   

   • The 2 years do not have to be consecutive periods - it might be one day at a time, as long as it totals 2 years.

2. "OWNERSHIP TEST:" Did you own the property for a 2 year total period within the last 5 years? For a married couple, only 1 spouse needs to be an owner for both to qualify, if both spouses meet the Use Test.

3. "BEFORE TEST:" Did you do a tax free sale within the last 2 years?

EXCLUSION AMOUNTS

• A single person can exclude $250,000 of profit;

• A married couple filing a joint return can exclude $500,000 [even if only 1 spouse meets the 2 out of 5 year ownership requirement, as long as they both lived there 2 years].

  [This probably allows a single person to sell his home today, get married on New Years Eve, and file a joint return excluding $500,000, as long as either spouse owned for at least 2 years, both spouses lived in the residence for 2 years, and neither sold a home tax free within the last 2 years.]

This rule can be used every 2 years. There is no more lifetime "tainted spouse" rule; the taint now wears off after 2 years!

Unlike the old law, now the property can be rented for several years and then sold.

Let us assume someone you know bought his home 20 years ago for $72,000. If he sells it for $800,000 his profit is $800,000 - 72,000 = $728,000. This is reduced by $500,000 since he meets the requirements of the new law. His age and whether he buys a new home is irrelevant. He has to pay tax on $228,000.

• Although §1034 (the 2 year rollover rule) is repealed, time in the old home rolled over tax free into the current counts toward the 2 out of 5 years rule for the new home.

  • Example I bought my home in 1980. On 1/1/97 I rolled over into my new home. I can now sell my new home and qualify for the 2 year ownership and use rules, since my holding period on rolled-over homes is "tacked on" to the holding period of my new home.

  • Of course, the adjusted basis today is computed with reference to profit rolled over previously under §1034 (the 2 year rollover rule). All my previously rolled over profit from every home I ever owned and rolled over, is now potentially taxable.

Reduced Exclusion: Proportional Rule

If you do not meet the 2 year rules, in 2 circumstances you may use the "reduced exclusion."

1. If you bought your new home before the date of enactment (8/5/97 for Federal purposes). [Note: if this was a home acquired in a prior 2 year rollover, since the holding period from the old home is "tacked on" to the holding period of the new home, you are deemed to meet the 2 year rules.]

   IRS claims that you may use the reduced exclusion only if you have not owned the home for 2 years, nor lived in it for 2 years. This means that if you have a rental property owned for many years, and have $250,000 of built-in profit, you and your spouse may not move in for 1 year and then sell and exempt all your profit (or half of the full exclusion amount). This may not be an accurate interpretation of this new law but that is the present IRS position.

2. If you buy after the date of enactment and are transferred for employment, health, or special reasons not yet defined.

Although Congress was confused and confusing, the 1998 IRS Restructuring Act has fixed the new law so that:

The exclusion amount is pro-rated. If you owned your home 16 months you exclude 66.6% (16/24ths) of the full exclusion amount ($250,000 / $500,000). If your profit is less than 66.6% of your $250,000 or $500,000 exclusion, nothing is taxable.

DIVORCE BREAK

Finally, we have a break for the "out spouse" after divorce.

• [Previously, if husband left the residence (either while the divorce was pending or afterward) and it was then sold, technically he was ineligible to use the 2 year rollover rule: it was no longer his residence (even if he had left the home last month).]

Now, the "out spouse" is eligible for these benefits if the "in spouse" is eligible, even if the "out spouse" has been out for many years if the sale is pursuant to the divorce or separation agreement.

Disaster Loss

If there is a disaster covered by insurance, it is taxed as a sale, rather than under the complex rules formerly applicable to such involuntary conversions.

Other Rules

• Time spent in a licensed facility for a person who formerly lived in the primary residence for at least 1 year out of the last 5 but is incapable of self-care still counts as time in the primary residence.

  • Grandma lived in the primary residence until she could no longer care for herself and went into the nursing home almost 4 years ago. She qualifies for the 2 of 5 years rule.

Still want to use the old law?

Some people might be better off under the old 2 year rollover rule coupled with the old over-55 rule. Under the old law, he could knock off $125,000 of profit and buy a new home on the golf course for $675,000 and pay no tax! He hates the new law, because he is not quite ready to retire.

Election to use old law:

1. If you were "in contract" or sold your old home before 8/5/97 (the day the President signed the law) you can elect to use the old law;

2. If before 8/5/97 you had already bought or were "in contract" to buy your new home [and the old law would have allowed you to sell the old home (within the next 2 years)] you can elect to use the old law.

New more liberal rules for Home Offices Deductions do not take effect until 1999.

CAPITAL GAINS

The following are the new Federal rules. As usual, the language used by the writers is nearly incomprehensible. The first sentence consists of 309 words and 20 paragraphs.

Here's what it means:
For 1997, capital gains are divided into 5 holding period terms.

There will be no indexing, (to avoid taxation on mere inflation gains).

For 1998, the 18 month holding period has been dropped to 12 months to qualify for long term rates.

Real estate depreciation recapture is 25%. We were able to deduct depreciation write-offs at our ordinary income rates (subject to the passive loss rules), now we have to give them back at 25%.

For example, you bought a property for $120,000 10 years ago, and since then took $25,000 as depreciation deductions. If you sell today for $200,000, you have $80,000 of capital gain taxed at the new capital gain rate, and $25,000 of depreciation recapture taxed at 25%.

However, there is no recapture for pre-May 7, 1997 depreciation on the sale of a property qualifying for the principal residence rules above. So, move into a property you used to rent out, live there 2 years, and sell it, paying tax only if your profit exceeds your exclusion amount, plus any post-May, 1997 depreciation is recaptured at 25%.

Options

Property acquired through options shall be treated as if acquired on the date of acquisition of the option. This means that if you were granted options today, exercised them in 2001, and sold them in 2010, you would NOT be eligible for the 5 year holding period rate, because the property is treated as if it were acquired today, before the eligible acquisition date for the 5 year holding period rate.

RETIREMENT PLAN WITHDRAWALS FOR FIRST-TIME HOMEBUYERS

After December 31, 1997After December 31, 1997, an individual can pull up to $10,000 out of a retirement plan penalty-free for acquisition costs for a first-time homebuyer can to purchase a principal residence. Of course, regular income tax is owed on the withdrawal, but the 10% penalty is waived.

A first-time homebuyer is a person who has not owned a home in the last 2 years. If his spouse owned a home in that time period, he is disqualified, so if you are planning on getting married and buying a home, make sure each spouse qualifies. [Or buy the home before getting married if your bride is disqualified.]

The $10,000 amount is a total lifetime amount.

A qualified person includes a child and grandchild and any ancestor of the taxpayer or his spouse.

I think this means your mother and father and grandfather and grandmother and your wife's mother... can each use this $10,000 rule to give us money to buy a home if we are otherwise qualified (and very nice to them). But they have to pay regular tax (figure 33% combined Federal and State) when they make the withdrawal.

ESTATE TAXATION CHANGES

$600,000 exemption increases SLOWLY to $1,000,000. Why so slowly? So our present crowd of politicians do not have to worry about dealing with the revenue decrease.

Family-Owned Business Exclusion

A great tragedy in this country is the forced sale of a family business to pay taxes. Mom and Dad work hard to create a $10,000,000 business and other assets of $2,000,000. They die and almost $6,000,000 is owed in tax. The business must be sold because there is no other way to pay the tax.

Now they have a break. If they meet many requirements (5 pages worth), Mom and Dad each can exempt $1,300,000 of certain family-owned businesses from taxation left to family members who continue to operate the business.

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