CAPITAL GAINS TAX CLARIFIED
The 1997 Taxpayer Relief Act permits taxpayers to retain, tax free, up to
$500,000 (for married couples) in capital gain upon the sale of a personal
residence. Single taxpayers may obtain up to $250,000.
To qualify for the exemption, the taxpayer must have occupied the home for
at least two of the previous five years prior to sale. The IRS clarified that
the act also provides taxpayers who live in the property for less than two
years the right to shield a portion of their gain from taxation. To qualify,
the sale of the property must have been because of a change in employment,
health reasons or other "unforeseen circumstances".
The law provides that this "proportional" benefit means that if a
taxpayer lives in the property for one year instead of two (and meets one of
the above reasons for sale), a single taxpayer may pay no tax on up to $125,000
worth of gain ($250,000 if married) as opposed to having to pay the tax that
would otherwise be owed.
The original law further was unclear regarding the test for "unforeseen
circumstances". There was no consent on what the phrase actually meant.
Even now there is little agreement on what constitutes "unforeseen
circumstances".
When the 1997 regulations were published, the "two out of the last five
year" rule made for some interesting scenarios under which sellers might
escape paying taxes. The seller did not have to be living in the home at the
time of the sale, but merely must have lived in the home two of the last five
years. One of the other aspects of this law was the ability for investors to
move into and occupy a rental property (thereby converting it into a personal
residence) for two years and then sell it and benefit from the up to $500,000
exemption. The IRS has now closed this loophole and new rules apply. An owner
reoccupying a home after having rented it, will have
only a partial tax exemption unless the occupancy continues for another full
five years.
Another clarification from the IRS involved the interest deduction regarding
loans that over encumber a property. The IRS indicates that the interest on
loan amounts that exceed the value of the home is not eligible for a tax
deduction. In other words, the equity interest deduction is limited to interest
on loan amounts up to but not greater than the market value of the home less
current acquisition indebtedness. $100,000 is the maximum limit, under all
circumstances, for the equity loan interest deduction benefit. In order to
enforce this rule, the IRS prepared a revised 1098 form to be
sent annually to all mortgage lenders and home loan borrowers, with a mandatory
copy to the IRS. Most ads that involve over encumbering property now suggest
(in the fine print) that a borrower should consult a tax advisor.
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