One Time Only!! Excluding Capital Gains on Home Sales
Zurndorfer, Edward A., The National Public Accountant
With the passage of the Tax Reform Act of 1986, several commonly used and popular tax deductions were either eliminated or substantially modified. One source of tax benefits that for the most part survived tax reform are those related to home ownership. Both home owners and sellers are able to take advantage these benefits to lower their annual tax liability and defer taxes on realized capital gains, respectively. Particularly for owners, mortgage interest and property tax expenses can constitute a significant portion of one's annual itemized deductions.
Home sellers also enjoy tax benefits. Among them are the deferral of tax on capital gain for sellers who reinvest the proceeds into a new principal residence and the one-time exclusion of up to $125,000 in capital gain for sellers 55 years or older at the time of sale.
One important difference between these two benefits is with respect to the seller's options in using these benefits. Unlike the mandatory deferral-of-gain provisions of Internal Revenue Code (IRC) Section 1034, the exclusion of gain on the sale of one's residence must be elected and is available only once.
This article focuses on the second benefit, the provisions of which are contained in IRC Section 121 (hereafter referred to as Code Section 121). It should be noted that in addition to qualified individuals, Code Section 121 also applies to qualified trusts. The type of trusts qualifying for the exclusion will also be discussed.
A Brief History of Code Section 121
Tax legislation has encouraged taxpayers to "buy up" when purchasing principal residences. The typical homeowner buys his or her "starter house" at a relatively early age, perhaps makes capital improvements to the residence, outgrows the house with the addition of more family members, sells it at a profit and buys a larger residence.
This process of purchasing more expensive (and perhaps larger) residences may be repeated indefinitely with several prerequisites for deferring tax on the realized gain from their sales. Under the provision of IRC Section 1034, tax on the realized gain from the sale of a principal residence will be deferred provided that the purchase price of one's new residence exceeds the adjusted sales price of the old residence. Other restrictions listed in IRC Section 1034 apply as well.
Through the years, tax on the realized gain from the sale of any number of principal residences can be deferred indefinitely provided the requirements of IRC Section 1034 are met. At a certain point, however, buying a larger residence or maintaining one's current residence may not be feasible, especially if the taxpayer is elderly and the majority of family members have "left the nest." Consequently, the taxpayer will sell and buy a less expensive (and smaller) home or move into a rental apartment. After deferring tax on the realized capital gain from the sale of these residences, the taxpayer could face a huge tax liability.
Congress understood the potential problems confronting these taxpayers. It therefore enacted Code Section 121 to relieve or reduce this possibly large tax liability.
Prior to 1978, taxpayers 65 years and older at the time of sale were eligible to exclude all gain on the sale of a principal residence if the adjusted sales price was $35,000 or less. In 1978, the age requirement was changed to 55 years or older at the time of sale and the maximum exclusion was increased to $125,000. These changes were made by Congress to shelter taxpayers from rapidly spiraling property values and to reflect the increasingly earlier age of retirement. Since 1978, neither the age requirement nor the limit on capital gain exclusion has been modified.
Specific Requirements of Code Section 121
Code Section 121 lists specific requirements. They are: * The taxpayer (or spouse) must be 5 5 years or older at
the time of the sale. …