Table of
Contents
I. Sale of Principal
Residence
II. Capital Gains
President Bush signed The Jobs and
Growth Tax Relief Reconciliation Act of 2003 (the "2003 Act")
on May 28, 2003. The 2003 Act makes
important changes to taxation laws including, among other
matters, lower capital gains tax rates, acceleration of a
reduction in tax rates, increased child tax credits and a
reduction in the so-called marriage
penalty. Additionally, the Taxpayer Relief
Act of 1997 (the “1997 Act”) and the IRS Restructuring and
Reform Act of 1998 (the “1998 Act”) provide for an exclusion
from income for certain amounts of gain from the sale of a
principal residence. This Q&A discusses
portions of the 2003 Act, the 1998 Act and the 1997 Act having
an impact on capital gains treatment for the sale of real
property and providing an exclusion from income for gains from
the sale of a principal residence.
This legal memorandum
is necessarily general in nature and is not intended
to cover every fact situation. Slightly
different facts may produce different
results. Accordingly, parties should
consult a professional tax advisor if advice is needed in
connection with a particular transaction.
This analysis is subject to change
as experience is gained with application of the provisions of
the 2003, 1998 and 1997 Acts to actual situations and as the
Internal Revenue Service issues guidance to those
provisions.
I.
Sale of Principal Residence
Q 1.
What happens if I sell my principal
residence?
A.
Individuals are generally permitted to exclude from income up
to $250,000 ($500,000, in general, for married couples filing
a joint return) realized on the sale or exchange of their
principal residence.
Q 2. May
I use this exclusion more than
once?
A.
Yes, but generally not more than once every two
years. In order to qualify, you must have
owned and used the property as your principal residence
for at least two years during the five-year period ending on
the date of the sale or exchange. In
addition, the two-year periods do not have to be
continuous.
Q 3. May
I use this exclusion in connection with Internal Revenue Code
("IRC") section 1034 "rollover" of gain on the sale of my
principal residence if I purchase a home of equal or greater
value?
A.
No. The IRC section 1034 provision allowing
a delay in the recognition of gain when purchasing a
replacement residence of equal or greater value was repealed
by the 1997 Act.
Q 4. May
I still take a one-time exclusion of
$125,000 of gain from the sale of my principal residence if I
am age 55 years or older?
A.
No. This exclusion was also repealed by the
1997 Act.
Q 5. If I
have previously used the $125,000 exclusion of gain, am I
prohibited from using the new $250,000 ($500,000 for married
couples filing jointly) exclusion of gain?
A.
Generally no. Even if you have
previously taken the one-time $125,000 exclusion, if you are
otherwise eligible for the exclusion you can take advantage of
the $250,000 exclusion ($500,000 for married couples filing
jointly) as often as you meet the requirements.
Q 6. How
does the exclusion apply to married
couples?
A.
The $500,000 exclusion applies to married couples filing
jointly when all of the following conditions are
met:
- Either spouse meets the ownership
requirement;
- Both spouses meet the use requirement;
and
- Neither spouse has had a sale of their
principal residence in the preceding two years subject to
the exclusion.
Q 7. What
if I marry someone who has used the exclusion within two years
prior to our marriage?
A.
Even though your spouse has used the exclusion within two
years prior to your marriage, you would still be allowed a
$250,000 exclusion. Once both spouses
satisfy the eligibility requirements and two years have passed
since the last exclusion was allowed to either spouse, a full
$500,000 exclusion would be allowed for the next sale or
exchange of a principal residence.
Q
8.
What if I move before I have occupied my residence
for two years or before two years have elapsed since the last
time I sold or exchanged my principal
residence?
A.
If you fail to meet either two-year requirement, you
will still be entitled to a pro rata amount of the exclusion
as long as the failure to meet the requirement is because the
sale or exchange is by reason of a change in place of
employment, health or other unforeseen
circumstances.
The 1998 Act provides that this
ratio is that portion of the $250,000/$500,000 exclusion equal
to the fraction of the two years that the ownership and use
requirement is met. Therefore, an unmarried
taxpayer who owns and uses a principle residence for one year
and then sells because of a job transfer may exclude up to
$125,000 of gain (one-half of the regular $250,000
exclusion).
Example: Ms. Seller purchased and
occupied her principal residence in 1998.
One year later, she is transferred by her employer to another
city and sells her house for a $100,000
gain. Because she occupied her residence
for one-half of the required two years, Ms. Seller is entitled
to exclude up to one-half of the $250,000 otherwise allowed,
thereby covering her entire $100,000 gain.
This is a change from the IRS’s previous position allowing her
to exclude only one-half of her gain, or
$50,000.
Q 9.
Are there clarifications to the permissible reasons for
sale or exchange allowing a pro rata
exclusion?
A.
Yes. Treasury regulations provide
clarifications and safe harbors for the exemptions from the
two-year period. Treasury Regulation
1.121-3T provides that a sale or exchange is by reason of a
change in employment, health, or unforeseen circumstances only
if the primary reason for the sale or exchange is a
change in place of employment, health or unforeseen
circumstances. The regulation provides the following
guidelines and safe harbors:
Place of
Employment
Generally, a sale or exchange is deemed
to be a change in employment if the primary reason for the
sale or exchange is a change in the location of a qualified
individual’s place of employment. (See
Question 10 for a definition of qualified
individual.)
The regulation provides a distance safe
harbor if (i) the change of employment occurs during the
period of the taxpayer’s ownership and use of the property
as the taxpayer’s principal residence, and (ii) the
individual’s new place of employment is at least 50 miles
further from the residence sold or exchanged than was the
former place of employment, or, if there was no former place
of employment, the distance between the individual’s new
place of employment and the residence sold or exchanged is a
least 50 miles.
For purposes of the regulation,
employment includes starting a job with a new employer,
continuing employment with the same employer, and starting
or continuing self-employment.
Health
A sale or exchange is by reason of
health if the primary reason for the sale or exchange is to
obtain, provide, or facilitate the diagnosis, cure,
mitigation, or treatment of disease, illness, or injury of a
qualified individual, or to obtain or provide
medical or personal care for a qualified individual
suffering from a disease, illness or
injury. A sale or exchange that is merely
beneficial to the general health or well-being of the
individual is not a sale or exchange by reason of
health.
The regulations provide a safe harbor if
a physician recommends a change of residence for reasons of
health. (See Question 10 for a definition of
qualified individual.)
Unforeseen
Circumstances
A sale or exchange is by reason of
unforeseen circumstances if the primary reason for the sale
or exchange is the occurrence of an event that the
taxpayer does not anticipate before purchasing and
occupying the residence.
The regulations provide a safe harbor
for any of the following events occurring during the
taxpayer’s ownership and use of the residence as the
taxpayer’s principal residence:
1. The
involuntary conversion of the residence;
2.
Natural or man-made disasters or acts of war or terrorism
resulting in a casualty to the residence;
3. In the
case of a qualified individual:
a. Death;
b. The cessation
of employment as a result of which the individual is
eligible for unemployment compensation;
c. A
change in employment or self-employment that results in
the taxpayer’s inability to pay housing costs and
reasonable basic living expenses for the taxpayer’s
household (including amounts for food, clothing, medical
expenses, taxes, transportation, court-ordered payments,
and expenses reasonably necessary to the production or
income, but not for the maintenance of an affluent or
luxurious standard of
living);
d. Divorce or
legal separation under a decree of divorce or separate
maintenance;
e. Multiple
births resulting from the same pregnancy;
or
4. An event determined
by the Commissioner to be an unforeseen circumstance to the
extent provided in published guidance of general
applicability or in a ruling directed to a specific
taxpayer.
(See Question 10 for a definition of
qualified individual.)
Q 10. Who is a
“qualified individual”?
A.
Qualified individual is defined in the regulations as
the taxpayer, the taxpayer’s spouse, a co-owner of the
residence, or a person whose principal place of abode is in
the same household as the taxpayer. For
purposes of the pro-rata exclusion of gain for a sale or
exchange due to health only, a qualified individual
also includes (i) an individual with a relationship described
as a dependent in IRC section 152(a)(1) through (8), without
regard to whether they are actually a dependent, or (ii) a
descendent of the taxpayer’s
grandparent.
Q 11. What if I
do not qualify for a safe harbor?
A. The
regulations provide the following factors, which may be
relevant in determining the taxpayer’s primary reason for the
sale or exchange:
1.
The sale or exchange and the circumstances giving rise
to the sale or exchange are proximate in
time;
2.
The suitability of the property as the taxpayer’s
principal residence materially changes;
3.
The taxpayer’s financial ability to maintain the
property materially changes;
4.
The taxpayer uses the property as the taxpayer’s
residence during the taxpayer’s ownership of the
property;
5.
The circumstances giving rise to the sale or exchange
are not reasonably foreseeable when the taxpayer begins
using the property as the taxpayer’s principal residence;
and
6.
The circumstances giving rise to the sale or exchange
occur during the period of the taxpayer’s ownership and use
of the property as the taxpayer’s principal
residence.
Q 12. May I
deduct a loss on the sale of my principal
residence?
A.
No. Although there were discussions about
allowing homeowners to deduct losses on the sale of their
principal residence, this provision did not become
law.
Q 13.
If I have gains from the sale of my principal residence
above the $250,000/$500,000 exclusion limits, what tax rate
will I pay?
A.
Depending on the length of time you owned your principal
residence, your gain may be taxed at the more favorable
capital gain rates discussed below. See
Section II, below.
Q 14.
Are there more special rules?
A.
Yes, including, among others, the following:
- A taxpayer can elect not to have the
exclusion apply to any sale or exchange.
- Certain periods an individual resides
in a nursing home on account of physical or mental
incapacity are included as part of the two-year use
requirement if certain other rules apply.
- An individual whose spouse is deceased
on the date of the sale of the property can include the
period the deceased spouse owned and used the property
before death.
- An individual is treated as using the
property as his or her principal residence during any period
of ownership while the individual's spouse or former spouse
is granted use of the property under a divorce or separation
instrument.
Q 15.
What happens if I transfer my principal residence into a
revocable living trust?
A.
IRC section 676 provides that a grantor (the person who
creates and funds the trust) is treated as the owner of the
property when the grantor retains the power to revoke the
trust and revest title in him or herself.
The 2003 Act does not change this
provision. This means that the $250,000
exclusion ($500,000 if married filing jointly) applies to a
sale or exchange by a revocable living trust so long as the
grantor of the trust and owner of the property before it was
conveyed to the trust are the same person and that person,
either as owner or grantor, has owned and used the property as
his or her principal residence for two of the previous five
years. In other words, because the grantor
is still treated as the owner of the property, the transfer
into the trust is not a taxable event.
Q 16. May I utilize an
IRC Section 1031 (tax-differed exchange) in connection with an
owner-occupied residence?
A. No. However, individuals
sometimes exchange one rental property for another planning to
move into the acquired property and, after living in it for
two years, sell it and take advantage of the capital gains
exclusion. This sometimes occurred as soon as three or four
years after the acquisition. As of October 22, 2004,
this is no longer possible. Pursuant to the American Jobs
Creation Act (signed by President Bush on October 22, 2004), a
property acquired in a 1031 exchange and later converted to a
principal residence must by owned for five years from the date
of the exchange before the owner can claim the capital gains
exclusion. Therefore, in order to take advantage of a 1031
exchange and the capital gains exclusion, the owner must both
have used the acquired property as a principal residence for
two years and owned it for five years.
II. Capital Gains
Q 17.
What are the basic changes to the capital gains tax
structure?
A.
Basically, the 2003 Act reduces the maximum rate on the net
capital gains rate of an individual (net long-term capital
gains less net short-term capital losses) from 20 percent to
15 percent. Net capital gains previously
taxed at 10 percent will be taxed at 5 percent.
Q 18.
Has the holding period for long-term capital gains
changed?
A.
In order to qualify for long-term capital gains treatment,
property must be held for more than 12 months.
Q 19.
Are there further capital gains tax rate
reductions?
A.
In 2008, the capital gains tax rate for gains taxed in the
lowest tax bracket (5 percent) will be reduced to
zero.
Q 20. When do the
reductions in capital gains take
effect?
A. The
2003 Act took effect May 6, 2003 and applies to taxable years
ending on or after May 6, 2003. There are
special transitional taxation rules for taxable years
including May 6, 2003.
Q
21. Do
these capital gains rates expire?
A.
Unless Congress extends them, the
capital gains rate reductions will sunset December 31, 2008,
at which time the rates will revert to 20 percent and 10
percent.
Q 22. Are there
any changes to depreciation recapture
rules?
A.
No. Generally, when selling investment real
property, a tax is imposed on all amounts previously taken as
depreciation. Under prior law, these
amounts were taxed as ordinary income and not capital
gains.
The 1997 Act provides for a 25
percent maximum tax rate on any gain attributable to
depreciation already claimed on the property in the case of
real property for which the maximum tax rate is reduced to 15
and 5 percent. Although there was an effort
to reduce the recapture rate, no reduction
materialized.
Example: Ms.
Seller purchases a triplex for $200,000 after January 1, 2001,
and takes depreciation deductions of $50,000 over the six
years she owns it. She sells the duplex for
$300,000. Her basis in this property is
reduced to $150,000 because of her deductions for
depreciation, and she would have a $150,000
gain.
Under the 2003 Act, she would be
taxed at a 15 percent (or 5 percent) rate on the $100,000
portion of gain over her original $200,000 basis and at a 25
percent rate on the $50,000 portion of gain attributable to
her depreciation deduction.
Q 23. Can you
provide a summary of the capital gains tax
rates?
A.
Yes. Sales of assets held more than 12 months and sold
on or after May 6, 2003 qualify for the 15 percent capital
gains rate (5 percent for lowest income taxpayers), with
special transitional rules for sales in taxable years
including May 6, 2003. The capital gains
rate reverts to 20 and 10 percents for assets held for more
than 12 months and sold after December 31,
2008.
Q 24. Can I
still take advantage of an IRC section 1031 "like-kind"
exchange?
A.
Yes. The tax-free exchange
of "like-kind" property used in a trade or
business is not affected by the Act.
Q
25.
Where can I obtain additional
information?
A. This memorandum is just
one of the many legal publications and services offered by
C.A.R. to its members. For a complete listing of C.A.R.’s
legal products and services, please visit C.A.R.
Online at www.car.org.
Copyright© 2004 CALIFORNIA ASSOCIATION OF
REALTORS® (C.A.R.). Permission is granted to C.A.R. members
only to reprint and use this material for non-commercial
purposes from the C.A.R. Legal Department. Other
reproduction or use is strictly prohibited without the express
written permission of the C.A.R. Legal Department. All rights
reserved.
The information contained herein is believed
accurate. It is intended to provide general answers to
general questions and is not intended as a substitute for
individual legal advice. Advice in specific situations may
differ depending upon a wide variety of factors. Therefore,
readers with specific legal questions should seek the advice
of an attorney.
