Capital Gains Tax Loophole Helps Sellers

In case you thought the federal tax laws couldn’t get any more favorable to homeowners after two major reform bills in less than two years, think again.

Tax specialists on Capitol Hill say many taxpayers have overlooked key “effective date” provisions hidden in the fine print of the 1997 and 1998 tax laws that bestow even more goodies on certain sellers of homes.

The provisions could be especially helpful to people who want to sell their homes tax-free in the coming months but don’t think they qualify under the 1997 and 1998 tax laws’ strict two-year minimum ownership rules on capital gains.

Here’s what’s involved:

Congress substantially liberalized federal tax treatment of most home sales in the 1997 Taxpayer Relief Act. Under that law, individual home sellers are permitted to keep up to $250,000 in capital gains ($500,000 for married sellers who file taxes jointly) on sales of houses they’ve used as a principal residence for two of the prior five years.

Congress then sweetened the deal even further in the 1998 Internal Revenue Service Restructuring and Reform Act, signed into law this summer.

This year’s change cleared up an issue left fuzzy by the 1997 law: The tax treatment of people who sell for a gain in less than the two-year minimum.

The 1997 law had said that such taxpayers--provided they sold because of employment changes, health reasons or other “unforeseen circumstances”--could take a pro-rata approach to shielding their gains from taxation.

If you owned and occupied your principal residence for 18 months and sold it, for example, you could pocket 18/24ths (three-quarters) of the gain you’d pocket if you lived in the house for a full two years.

The 1998 law clarified that the maximum gain you could multiply that residency fraction against is the full $250,000/$500,000 statutory amount, not your actual dollar gain on the sale.

That’s a potentially big money-saver for the thousands of Americans every year who are transferred or are forced to sell because of illness after living in their homes for less than two years.

But what about people who don’t qualify on the employment or health tests but simply want to sell after owning for less than two years? Do they have to pay capital gains taxes on their profits after the sale?

Here’s the good news for at least some of them: Thanks to “effective date” provisions that Capitol Hill tax experts say were buried so deep in the legislative fine print that they’ve been widely overlooked, anyone who owned his or her home as of Aug. 5, 1997, and now wants to sell it can do so and reap the full tax-saving benefits of the 1998 law without meeting the employment, health or “unforeseen circumstances” tests.

They must, however, meet the “principal residence” and use requirement, and they must close their sale before Aug. 6, 1999.

Put another way: if you purchased your current home before Aug. 6, 1997--the effective date of the 1997 tax law on this issue--you have a “free hit” on use of the valuable capital gains residence-period formula until Aug. 5, 1999.

It’s a free hit in that the IRS won’t hold you to the job change or health tests and won’t force you to figure out what an “unforeseen circumstance” is.

According to one federal legislative expert, Congress tucked this into the law--Section 312(d)(3) of the 1997 Act--to give homeowners “some wiggle room” for two years to adjust to the new system and to obtain regulatory guidance from the IRS.

To illustrate how this works in real life, take the case of a couple who bought their home in July 1997. Now they’d like to move to a different neighborhood to send their kids to better schools.

Thanks to their strong local real estate market, their house has racked up a $50,000 to $60,000 gain since they’ve owned it. They don’t qualify for the pro-rata capital gains exclusion for employment or health reasons, and they are reluctant to take a chance on arguing to IRS auditors that their kids’ school situation constitutes an “unforeseen circumstance.” So they assume that if they sell this fall, they’ll have to pay taxes on their full gain.

But they’re in luck. Under the “effective date” loophole, they can sell without worrying about meeting the standard test--as long as they conclude the deal by next Aug. 5.