Congress May Boost Sellers’ Tax Break

An election-bound Congress has come up with the seemingly impossible: Still another capital-gains tax break for American home sellers.

After passing the Taxpayer Relief Act of 1997--which effectively transformed most home sale profits into tax-free cash--what more could Congress possibly give to home-owning households?

Here it is: A “technical correction” to the 1997 law that provides more generous tax benefits for potentially thousands of homeowners per year who have to sell their residences after living in them for less than two years.

These include people who are suddenly transferred by their employers, who get sick and have to sell, or who experience some other “unforeseen circumstances” that force them to move.

Under the 1997 Tax Act, a homeowner who wants to reap the maximum capital-gains tax “exclusion” on a property must live in and use the home as the principal residence for at least two of the five years preceding the sale.

The maximum benefits are substantial: Married homeowners who file joint federal tax returns can exclude up to $500,000 tax-free if they meet the two-year principal residence test. Single-filers can exclude up to $250,000.

But what if you don’t quite meet the two-year standard? The 1997 law set up a pro-rata formula for home sellers who use a property as their principal residence for a period of months, but not the mandatory two years.

The formula allows homeowners who have to sell because of employment or health changes--and thereby flunk the two-year test--to create an exclusion fraction to calculate their taxable gain.

For example, a seller who gets transferred 18 months after occupying a house (three-fourths of the minimum time required) would be allowed to take three-fourths of the applicable gain tax-free.

But three-fourths of what? Of the maximum statutory exclusion limits ($250,000/$500,000), or of his own specific gain?

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Say, for instance, that you and your spouse have owned and used your house as a principal residence for 18 months. Thanks to a hot local real estate market, the home’s resale value appreciated enough to give you a $100,000 gain. Your employer offers you a promotion to a branch office 2,000 miles across the country, and you sell your home.

At tax time, how do you compute your gain? Do you get to exclude three-fourths of the $100,000, paying tax on just $25,000? Or do you get to pocket the entire $100,000?

Curiously, the 1997 tax law never really answered that key question.

But now Congress appears to be on the verge of doing so, in the form of a technical correction tucked away in IRS legislation that’s expected to pass both houses by late spring.

Congress’ answer is a generous one: The exclusion fraction should be applied to the maximum statutory limit ($250,000/$500,000), rather than your own specific gain. That’s great news for virtually anyone with a taxable gain on the sale of a home owned and lived in for less than two years out of the previous five years.

Rather than being forced to pay tax on at least a portion of your gain, you may well be allowed to pocket it all, assuming the new provisions are enacted.

Even if your gain is relatively modest by today’s rapidly inflating real estate standards in some markets--say a $40,000 profit on a high-cost home over a one-year holding period--you get to keep it all, rather than have your cautious accountant tell you to pay tax on $20,000, half your profit.

Obviously, owners of upper-bracket houses in strong markets will reap the most from the new rules. If you’re a single taxpayer and have racked up a $200,000 profit in 20 months of ownership of a principal residence and then get transferred, the new language will let you keep the full $200,000 because you’ll now apply the five-sixths fraction (20 out of 24 months) to $250,000, not to the $200,000 gain. Using the former, cautious approach, you could have paid capital-gains taxes on $33,334 of the $200,000 ($200,000 multiplied by five-sixths).

Not everyone comes out a winner under the new plan, however. A few short-term super-gainers will end up paying more. For example, if your sale profit on that red-hot condo in Manhattan you’ve owned as a single for a year comes to $500,000, you won’t be able to exclude the full $250,000 you might have under the old, murkier rules.

Instead, you’ll be limited to one-half of the $250,000 single-filer maximum--$125,000--not one half of your actual profits.

Distributed by the Washington Post Writers Group.