Sale of Rental House Isn’t Tax-Free
QUESTION: My wife and I sold our home last February after reading your column about the one-time exclusion from taxable income of up to $125,000 in profits from the sale of a home. We had every reason to believe we would qualify and not have to pay taxes on any of the profit from our house, which we sold for $67,000. Both of us are over 55 years old, we had never taken the exclusion before and we owned and lived in the house for more than three years. So we were very disturbed to hear from our accountant that only half of our profit was tax-free because ours was a two-family home. Your article made no mention of such a rule. Is he correct?--H. N. A.
ANSWER: The mere fact that your home was a two-family home isn’t in itself grounds for taxing half of your profit. But if you shared the ownership of the house with someone else or if you rented out half of the house, then different rules do apply.
Say you and your wife owned half of the place and a family friend owned the other half. Obviously, you and your wife would only be entitled to tax protection from half of the profits since the other owner would be entitled to the break on the other half. In such cases, each of the two owners must meet the IRS’ age, ownership and use tests if both are to take advantage of the one-time exclusion. But it isn’t necessary for both owners to claim exclusions at the same time in order for one to do so.
My suspicion, however, is that yours was a situation where you owned the whole place and rented out half of it. In such cases, the portion you rent out is subject to the rental-property provisions of the tax code. That means there are some trade-offs. You get some tax breaks that you wouldn’t otherwise receive. But on the flip side, you have to pay taxes on part of the profit you receive when you sell the property. Your accountant should have explained that to you--if not when you started renting out half of the house, then certainly when you sold the place.
In essence, you need to treat the house as two homes. You are entitled to exclude from taxes all of the profit attributable to the part of the house you lived in. So, if it was split 50-50, your exclusion is half of the profits.
What your tax bill will be on the rental property side is harder to figure. You need to know the answers to such esoteric questions as “what was the original basis in the property, and what was the basis when you sold the house?”
But before we go into that, the most important thing for you to know is that you won’t , under any circumstances, pay ordinary income taxes on the full profit for this part of your house. The reason: You will owe capital-gains tax on this part of the profit; not ordinary income tax. So instead of facing a tax bill on all of this half of the profit, you’re looking at paying taxes on only 40% of this share of the profit. That means your maximum effective tax rate on this half of the profit will be 20% rather than the 50% you might have feared.
The bad news is that the profit, for tax purposes, from the rental part of your house is bound to be higher than that for the part you used personally because over the years you probably have been gradually reducing the so-called basis of the rental property.
This accountants’ parlance is simply a measuring stick by which your property investment is valued for tax purposes. From the original cost of the property--the original basis--you deduct such things as depreciation, amortization, depletion and casualty losses--expenses for which you have been allowed tax deductions. Because these adjustments lower your original basis, your profit, for tax purposes, will be larger when you sell the property.
Q: I work for a company that has always offered stock options to the top brass. Now it has decided to offer them to about two-thirds of the employees, including me. I’ve never had to deal with this before, and I’m wondering if you can tell me when I will have to pay taxes on them. Is it when I get a formal notice of my right to exercise them or when I actually exercise that right?--L. R.
A: Neither. You’re taxed on the options when you sell the stock acquired through your options.
As long as you follow the rules for holding on to option stock, your tax will be figured using the more favorable capital-gain treatment. If you sell the stock too soon, you will be taxed as if you received ordinary compensation in the year in which you dispose of the stock. The bottom-line meaning of that distinction is that your top tax rate is 20% if you follow the rules and 50% if you don’t.
Note: In a recent column, readers were advised to call a number in Washington for schedules of impending Treasury note and bond issues. A reader points out that a second way to get this information is to write the Department of the Treasury, Bureau of the Public Debt, Room 2134, Main Treasury Building, Washington, D.C., 20226. Ask to be put on the mailing list.
