Capital Gains Tax Liability: How To Legally Avoid Or Minimize Your Tax Liability When Selling Your Principle Residence
This is a subject I have covered in the past but one that a number of people have recently raised again which is why I am revisiting it this month.
This is a summary of the Taxpayer Relief Act of 1997 (Section 121) which repealed and replaced the tax deferral provisions contained within Section 1034 of the Internal Revenue Code.
Generally, a Taxpayer can sell real property held and used as his or her primary residence and exclude from gross income up to $250,000 in capital gain taxes if the Taxpayer is single and up to $500,000 in capital gain taxes if the Taxpayer is married and filing a joint income tax return. The Taxpayer is required to have lived in the real property as his or her primary residence for at least 24 months out of the last 60 months (two out of the last five years).
Note that the 24 months do not need to be consecutive and there are certain exceptions to the 24 month requirement when a change of employment, health, or some other unforeseen circumstances has occurred.
Section 121 is effective for dispositions of real property held as a primary residence after May 7, 1997. Taxpayers can complete a 121 exclusion no more than once every two years.
Taxpayers should carefully monitor the amount of “built-up” capital gain in their primary residence and may want to seriously consider selling their primary residence before the capital gain tax liability exceeds the $250,000 or $500,000 limitation. The Taxpayer’s capital gain tax liability in excess of these exclusion limitations will be taxable. A sale of the primary residence would preserve the tax free exclusion of the capital gain and would allow the Taxpayer to acquire another primary residence and start all over again.
Special legal, tax and financial planning is needed in circumstances where a Taxpayer already has a significant capital gain tax liability in excess of the $250,000 or $500,000 exclusion limitation. For example, the primary residence could be converted to rental or investment property and then sold as part of a 1031 exchange after it has been rented for a sufficient amount of time in order to demonstrate the Taxpayer’s intent to hold the property as rental or investment property. This would allow the Taxpayer to dispose of his or her primary residence, defer all of the capital gain tax liability, and diversify and allocate the capital gain tax liability pro-ratably over a number of rental properties clearing the way for further financial, tax and estate planning opportunities.
The tax liability calculation is not so simple when divorce or the death of a spouse occurs during the period of home ownership. If you have any doubts about how any capital gains you make will affect your tax liability, you are strongly recommended to discuss the implications with your tax advisor.
Tags: Capital Gains Tax, Selling