Tax Breaks, but Also Pitfalls, Await Older Homeowners

Homeowners who sell their property are entitled to several important tax breaks under the law. One that is especially beneficial to older taxpayers is the right to exclude from tax as much as $125,000 of any profits earned from the sale of a house.

This benefit, however, is a one-shot deal, available to those 55 and older, and once used it is gone forever. This is true even if the homeowner uses only part of the $125,000, or if he or she could have deferred the tax another way. And, as several recent court cases make clear, if you take the exclusion and then find you would have been better off having saved it, you are likely to be out of luck.

The principal problem with this exclusion “is in planning when to use it,” said Arthur Auerbach, a certified public accountant in Vienna, Va. But he noted that there are also a number of technical requirements--such as whether the property is the taxpayer’s principal residence and whether he or she has lived in it long enough--that can create traps for the unwary.

Part of the confusion surrounding the exclusion arises from another benefit for homeowners: the ability to defer tax on profits from the sale of a residence if they are rolled over into another residence of equal or greater value. Properly used, the exclusion and the rollover can mean thousands of dollars in tax savings to homeowners, but a misstep can be costly.

“It does create confusion,” said William G. Brennan, a financial planner with offices in Washington. “People have difficulty with the concept of rollover--what does it mean, and the $125,000, what does that mean? Can I apply both?”

Indeed, the complexity surrounding these tax provisions, especially the $125,000 exclusion, is the sort of thing that accounts for the appeal of Republican tax-reform proposals, such as the flat-tax plan of House Majority Leader Dick Armey (R-Tex.).

To take best advantage of the provision, a homeowner not only must get all the tax steps right, but in many cases must also accurately forecast the future.

Since married couples are treated as a unit for purposes of the $125,000 exclusion, people divorcing and remarrying must be careful when they buy and sell and tie the knot. If a married couple takes advantage of the exclusion, then divorces, their exclusion is gone. And if one later remarries someone who has never used the exclusion, that person’s exclusion is wiped out also.

The courts aren’t cutting taxpayers any slack in the event of error or miscalculation.

If you are over 55, or will be soon, and are contemplating selling your home, experts offer this advice:

* Make sure you qualify. You have to be 55 (or older) on the date of the sale, not the year in which the sale takes place. If you own the property jointly with your spouse and file a joint return, you qualify if either of you is 55.

If you file separate returns, you both must meet all the tests and each of you gets a $62,500 exclusion. If one spouse is under 55, that spouse can’t take the exclusion and loses his or her right to one later on. However, one spouse cannot take it without the other’s consent.

Also, the property has to be your principal residence, and you must have owned and lived in it for at least three of the past five years, though it doesn’t have to be continuous.

* Look at the amount of your gain and what you plan to do with it. If you are buying another home and can roll over your gain, it usually makes sense to do that. Or you can combine the rollover and the exclusion--if you buy a cheaper house, you may want to roll part of your gain over into that and then use the exclusion to protect some or all of the rest.

“If you’re going to use the entire exclusion, then it becomes a real easy decision,” said planner Brennan, but if you find you will be using the exclusion to shelter a small gain, it may be better to pay the tax and save the exclusion for later.