Tax laws regarding home sales have shifted in the past two decades. Prior to 1997, capital gains on a home sale were taxable. The only way to avoid capital gains tax was to buy another home for the same amount of a home sale, or higher. This practice is called a “1031 exchange,” named after the IRS code that allowed for the deferral of capital gains taxes. There are some restrictions on 1031 exchanges. First, you had to buy a “similar” type of property as what was sold–residential or commercial. Second, you had just 45 days to identify the property you wished to buy, which can be difficult in hot real estate markets where properties don’t last long.
Taxpayer Relief Act of 1997
But when the Taxpayer Relief Act of 1997 became law, the home-sale tax burden eased for millions of residential taxpayers. Now, the first $250,000 gain on any home sale is tax-free. A married couple can double that exemption to $500,000. The exemption is available for any property you have lived in for at least two of the previous five years.
The 1031 exchange can still be used for gains that are higher than what is the common exemption. This can be valuable in California, especially for people that have owned their homes for many years. In the San Francisco Bay Area, for example, someone that has owned a home for twenty or more years is likely to see a gain higher than $250,000 and could seek tax deferral for the gain with a 1031 exchange. If you’ve used a 1031 exchange in the past, you can still claim the $250,000 exemption if the 1031 exchange took place more than five years ago.
Multiple Exemptions Allowed
There is no limit on home many times you can use the home sale $250,000 exemption, but the property must be your principal residence and you must have lived in it for at least 24 months during the past five years. The 24 months don’t need to be consecutive, and there are some exceptions for traveling, military service, relocation for employment, disability, and other events that might require a change of living situation that is outside of a homeowner’s control.
Married couples may exclude up to $500,000 of gain if they file a joint return and neither spouse has claimed an exemption on the sale of another home within the past two years. If one spouse meets the ownership requirement, both are considered to have met the requirement.
The gain amount is the difference between what you paid for a house and what you sell it for, as well as all capital improvements you’ve made, such as adding a room or finishing a basement. Also, if you sold a home prior to the 1997 law change and rolled the profit into the home you’re now selling through a 1031 exchange, you must account for that rollover amount; your basis will decrease by the amount of gain you postponed years ago.
If your home is also used for business such as a home office or a garage used to store business equipment, you can typically still claim the full homeowner’s exemption. If your home contains a separate building used for business, such as a barn or ground floor storefront, you may not be able to claim the full exemption as different regulations apply.
The IRS offers worksheets for calculating taxable gains and exemptions under multiple scenarios. Call me for more information on real estate taxes at (415) 883-5200.