Capital gains and your home sale

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Sold sign outside house sale | Martin Barraud/OJO Images/Getty Images

Martin Barraud/OJO Images/Getty Images

What is Capital Gains Tax?

Capital gain tax, abbreviated as CGT, is a tax imposed on the profit (capital gains) resulting from the sale of an investment. For example, capital gains are commonly realized after the sale of stocks and property.

To calculate capital gain, subtract the Purchase Price from the Sales Price, such that (Sale Price) - (Purchase Price) = Capital Gain. Homeowners are familiar with capital gains tax.

Homeowners already know the many tax breaks that Uncle Sam offers, most notably mortgage interest and property tax deductions. Well, he also has good tax news for home sellers: Most of them won't owe the Internal Revenue Service a single dime.

When you sell your primary residence, you can make up to $250,000 in profit if you're a single owner, twice that if you're married, and not owe any capital gains taxes.

"Most people are not going to have a tax obligation unless their gain is huge," says Robert Trinz, senior analyst with Thomson Reuters Checkpoint.

Some sellers are surprised by this break, especially if they've been in their homes for a while. That's because before May 7, 1997, the only way you could avoid paying taxes on your home-sale profit was to use the money to buy another, more-expensive house within 2 years. Sellers age 55 or older had one other option. They could take a once-in-a-lifetime tax exemption of up to $125,000 in profits. And in all instances, there was Form 2119 to fill out to show that you followed the rules.

But when the Taxpayer Relief Act of 1997 became law, the home-sale tax burden eased for millions of residential taxpayers. The rollover or once-in-a-lifetime options were replaced with the current per-sale exclusion amounts.

"There is some logic to this law change because most people under the prior rules didn't recognize a taxable gain, because they rolled it over into another residence," says Trinz. "The change essentially makes it easier to dispose of your residence."

Still some requirements to meet

If you used pre-1997 rules for residential sales, don't worry. That doesn't disqualify you from claiming the exclusion on any residential sales now. The law change applies to all sales since it took effect.

Another bonus to the new rules? You don't have to buy another home with your sale proceeds. You can use the money to travel Europe in style, buy a recreational vehicle and drive across the country or get all those designer shoes you never could afford.

Even better, there's no limit on the number of times you can use the home-sale exemption. In most cases, you can make tax-free profits of $250,000, or $500,000 depending on your filing status, every time you sell a home.

Ah, but we are talking taxes here. You did notice that phrase "in most cases," didn't you? Before you put a "for sale" sign in the yard, you need to make sure your house-sale situation is one of those "most cases."

First, the property you're selling must be your principal residence. That means you live in it. This tax break doesn't apply to a house or other property that you have solely for investment purposes. In those cases, the usual capital gains rules apply.

You also must live in that principal residence for 2 of the 5 years before you sell it. This is known as the use test. It also means, practically speaking, each sale must be at least 2 years apart.

That still leaves you room to make some money on several properties. You can sell your residence this year, pocket any gain within the tax limits and buy a new residence. Then 2 years later, you can do the same thing, again and again, every 2 years.

And you no longer have to worry about that pesky prior-law reporting requirement. When your gain doesn't exceed the limit, you don't have to file anything with the IRS.

Second home sales take a tax hit

Owners of multiple homes, however, will now find it's not as easy to shelter sale profit as it used to be.

A provision of the Housing Assistance Act of 2008, the bill designed primarily to provide relief to some homeowners facing foreclosure, could cost the owners of a vacation or other type of 2nd property -- when they sell.

Previously, you could move into the 2nd property, make it your primary residence, live there for 2 years and then sell it and pocket most or all of the profit.

Now, however, even if you convert a 2nd piece of real estate to your primary home, you'll owe tax on part of the sale money based on how long the house was used as a 2nd, rather than your main, residence.

Special rules for married couples

While spouses get double the exclusion of single home sellers, couples also have some additional considerations when it comes to determining whether their sale is tax-free.

Either spouse can meet the ownership test. For example, the IRS says it's OK if you owned the home for the past 2 years, but you just added your new spouse to the title when you got married 6 months ago. Since you owned the residence for the requisite time, as joint filers, you have no problem meeting the ownership test even though your spouse wasn't an official owner for that long.

However, both spouses must pass the use test; that is, each must live in the residence for 2 years. But the shared use doesn't have to be while you file jointly. If you and your now-spouse shared the home for 1 1/2 years before tying the knot and then 6 months as newlyweds, the IRS will allow you to claim the exemption. But if your better half didn't move in until the wedding day, you're out of tax-exclusion luck.


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