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Taxes When You Sell Your Home
LEAVE IT TO Congress to take a simple idea — no more tax bills on the profit you make when you sell your home — and make a mess of it. But that’s what has happened with the rules governing home sales. The more government has thought about them, the more confusing the rules have become. What all this means is that you can’t, as everyone was hoping, just sell your house and pocket the cash. You’ve got to know the rules first, or you could become the horrified new owner of a six-figure tax bill.

First, the rule itself: If you’ve owned your home and have lived in it for two of the previous five years, then you can make a profit of up to $250,000 if you’re single or $500,000 if you’re married, with no tax bill. You may however owe state taxes. Never the less, this deal is so good that you should do everything you possibly can to get it.

At first glance, these exclusions seem pretty high. Who really makes a profit of a half a million dollars on a house? Maybe you. A Silicon Valley house bought 25 years ago for $100,000 could easily be worth more than a million bucks today. Of course, not everyone lives in the nation’s most insane real estate market, but there are other markets almost as hot.

More likely, though, you will top the limit because your gain includes all the profits you’ve made on any previous houses you’ve owned. Why? Because the old rules allowed people to roll over their gains into a bigger house without paying taxes, and that’s what most people did.

So when you calculate your gain under the current rules, you have to include the gains you rolled over into your current house. Say you’ve owned three homes over the past 20 years, and each one appreciated by $100,000 in the time you owned it. You probably rolled the profits from each home into the next, meaning you have $300,000 in accumulated gains. If you’re single, that means you’re going to have to pay taxes at the long-term capital gains rate (most likely 20%) on $50,000 of that profit. If you’re married, though, you are probably safely sheltered by the $500,000 exemption for joint filers.

Still confused? IRS Publication 523, available on the IRS Web site, has worksheets for calculating the cost of your house for tax purposes — including increases from improvements — and the exact amount of your gain. If you’ve rolled over your prior gains, you’ll need to dig up the tax return for the year of the last sale. In there, you should find Form 2119 (Sale of Your Home), which lists the cost basis of your current home, taking into account any gains rolled over from previous residences. You take that amount and add the cost of subsequent improvements to arrive at the final cost basis for your current home.

Do You Qualify?
Once you've got the dollars straight, you’ve got to make sure you actually qualify for the tax break. If you’ve owned your home and have used it as your principal residence for at least two years out of the five-year period ending on the sale date, you qualify. However, to claim the $500,000 joint return exemption, both you and your spouse must have used the home as your main residence for at least two years out of the five-year period. (Be careful of the "antirecycling" rule, which limits you to one exclusion every two years.)

What if you don’t meet these qualifications? You can get partial credit, provided you move for health reasons, or because your job location changed.

The rule works like this: Say you moved your family to a new town six months ago, just before Disney decided to build its next theme park down the road. Now your boss decides to transfer you. So you sell your house and make $100,000 on it. Since you’ve lived there for one-fourth of the two-year period required for a $500,000 gain exclusion, your maximum tax break would be $125,000, leaving you in the clear. This loophole still applies even if you took advantage of the gain exclusion just six months ago, when selling your previous house.

The Depreciation Dilemma
If you've rented your home or had a home office, things get a lot more complicated. In both cases, you would have taken a depreciation deduction for all or part of your home. Now you’re going to have to pay tax on your post May 6, 1997 depreciation deductions.

Here’s how it works. Say you used 25% of your home as a deductible home office the entire time you lived in the house, and you sell the house for a $100,000 profit. You’ll have to pay tax on the portion of your profit that came from the office, or $25,000. And since you’ve deducted the home office, that also means you’ve taken a depreciation deduction each year, which in this case totals, say, $5,000. That adds to your gain. The $25,000 profit will be taxed at the maximum 20% rate for long-term capital gains, and the $5,000 will be taxed at a special 25% rate under a specific rule for "unrecaptured Section 1250 gains." Your total tax bill: $6,250.

Don’t want to write that check? We don’t blame you. Here’s our advice: If you know you’ll be moving soon, give up the home-office deduction for two years. Then that portion of the house meets the two-out-of-five rule, and all of your profit will be tax-free, except the amount you deducted for depreciation after May 6, 1997.

Death and Taxes
When death, marriage or divorce is the reason for the sale, the new rules force you to act fast or smart or both. It’s the two-out-of-five-year requirement again.

If a spouse dies, the survivor can file a joint return for that year, meaning you’re safe if the profit is $500,000 or less. After that year, your exclusion drops to $250,000. Keep in mind that if you inherit your spouse’s portion of your home, your basis on that piece is stepped up to the market value as of the date of death. So your gain may not be as big as you think.

Divorce is also tricky under the new rules. If you sell the house before the divorce, you get the $500,000 exemption as long as you file a joint return. But if one spouse takes ownership after the divorce, the limit falls to $250,000.

In one common scenario, the two former spouses both continue to own their home. In this case, the nonresident will eventually fail to meet the two-out-of-five-year rule. When the house is sold, only the resident spouse gets the $250,000 exclusion. One way to avoid this trap is to have your divorce papers specify that one ex-spouse can continue to live in the home, for example, until the children reach a certain age or for a set number of years. Making this arrangement a written condition of the divorce allows the spouse who moved out to get credit for living in the house, keeping his or her $250,000 gain exclusion.

On a brighter note, if both members of a newly married couple own their own homes, they each get a $250,000 break, even though they will be filing jointly. But if one spouse has a huge gain on a house, it might pay for both of you to live there for at least two years before selling. As long as the sale is more than two years after the sale of the first home, then you’ll get the full $500,000 tax break for married couples. Not a bad way to start off a marriage.