How Capital Gains Tax Benefits Home Seller

QUESTION: I have been reading about President Bush’s proposal to cut the capital gains tax rate, and many commentators have suggested that this will only affect the rich.

My wife and I are in our early 60s, and plan to retire in a couple of years. We have made a lot of money by virtue of our house appreciation, and I am concerned that we will have to pay a lot of tax on our profit when we sell. We are not rich. Could you explain what this capital gains issue is all about?

ANSWER: Let us take an example that is quite typical in many parts of the country.

You purchased your house for $30,000 in 1966. You now plan to sell your house in 1990 for about $400,000. Your gain, without taking into consideration commissions, expenses and other similar deductions, is $370,000. You do not intend to roll the house over into another property, but you are entitled to the once-in-a-lifetime exemption of $125,000. Thus, your gain is $245,000.

Before Congress changed the law beginning in 1987, we had a capital gains tax rate. Oversimplified, taxpayers could deduct 60% of their net capital gain from gross income. The remaining 40% of net capital gain was included in gross income and taxed at regular rates.

At the top rate of 50%, this deduction meant, in effect, a maximum effective tax rate on long-term capital gains of 20% (50% top tax rate by 40% of net capital gain equals 20%).

Under the tax law that became effective in 1987, for all practical purposes, the capital gains tax was repealed. Thus, profit is now taxed at the regular taxpayers rate, which ranges between 15% to 33%, depending on income.

For married individuals filing joint returns, you are taxed on a rate of 15% for the first $30,950, 28% up to $74,850 and 33% on the difference between the latter figure and $155,320. Above that, there is a work sheet, which nets out to about 28%.

This is confusing for the average taxpayers, and obviously a bonanza for accountants. However, this is how it breaks down under our example.

Where you have made $245,000 in gain, under the old tax law (pre-1987) your tax was about $49,000 on this gain. Under the current tax law, you would have to pay about $70,000. This is effectively a $21,000 increase that you will have to pay.

Incidentally, for our calculations, I am assuming no other deductions and no other income.

President Bush has now proposed a graduated capital gains tax rate. Taxpayers who own property for at least three years would qualify for a 30% exclusion, which effectively translates into a 19.6% tax rate for individuals in the highest tax bracket.

If you held your house for only two years, 20% of the gain would be excluded, and if you only held your house for one year, only 10% of the gain would be excluded.

Under the Bush proposal, since you have held your house for more than three years, your tax would be about $48,000.

Thus, as you can see, there is a significant difference between the old capital gains rate (where your tax would be $49,000), the current tax law (where your tax is almost $70,000) and the President Bush proposal (where your tax would be about $48,000).

You do not have to be rich to be in this situation. Many people are finding that they are just unwilling or unable to hang on to their house, which has significantly appreciated in value. They are moving in with their children, moving into rental property or moving down so significantly, that they cannot take advantage of the roll-over tax benefits.

The current tax law affects all homeowners, be they rich or poor.

The Joint Congressional Committee on taxation has projected that those people who report gains year after year would be benefited more than those who report gain on a sporadic (or even one-time) basis.

According to the joint committee, 58.9% of the gains reported in a five-year period were reported by people who had gains every year. More than 81% of the profits were reported by taxpayers who had gains in at least three of the five years.

On the other hand, only 9.8% of the gains were collected by those who reported gains in only one of the five years, including those whose only capital gains were profits from the sale of a home, farm or business.

While 9.8% may be a very small statistic, it clearly affects a lot of homeowners.

In my opinion, it is not appropriate to reject a capital gains tax merely because the principal beneficiary may be the rich. Many homeowners relied on the great American dream of home ownership, only to find their dream was shattered because of the 1986 Tax Reform Act.

Congress is currently considering the capital gains tax revision. One interesting bill has been introduced by Rep. Dick Schulze (R-Pa.), a member of the House Committee on Ways and Means. This committee will have the primary responsibility of hammering out the new tax law.

Schulze’s bill (H.R. 1287), would exclude from taxation 100% of the gain on the sale of a homeowner’s principal residence.