Estate and mortgageTax Consequences Need Careful Consideration
Q: I purchased my first house in l950 for $45,000, and sold it in l990 for $500,000. My basis for tax purposes was $50,000. I took advantage of the once-in-a lifetime exclusion of $125,000, which was then in effect. I paid capital gains tax on $25,000 of profit and rolled over the balance by purchasing a condominium apartment for $300,000. The property is now appraised at $450,000 and I would like to sell it. Can you assist me in determining how much tax I will have to pay, if any. Both properties were my principal residence.
A:You certainly have done well on your real estate ventures.
Before responding to your question, I have to remind readers – especially the younger ones – of the tax rules which applied to real estate before the law changed in l997. Currently, the tax laws are quite favorable for consumers who own and sell their own home. If you are single, you can exclude up to $250,000 of gain from the sale of your house, on the condition that you have lived in the property two out of the five years before the property is sold. If you are married – and file a joint return – the exclusion goes up to $500,000.
However, before the l997 tax law changes, there were two important tax rules:
The roll-over: if you purchased a principal residence either within two years before or two years after you sold your principal residence, and if the new property was equal or greater in value than the selling price of your older home, you did not have to pay capital gains tax on the profit you made on the sale. This was only a deferral -- not an avoidance -- of the tax. You rolled over your gain in to the new property. Oversimplified, if you made a profit of $100,000 when you sold your first home for $200,000, and rolled over into a home which cost you $400,000, the $100,000 gain was used to reduce your tax basis on the new home. Thus, the $400,000 house you purchased had only a tax basis of $300,000. If you later sold the house for $500,000, even though you really only made a profit of $100,000 ($500,000 - $400,000), for tax purposes you made a profit of $200,000 ($500,000 - $300,000).
The once-in-a-lifetime exclusion: if you were 55 years of age when you sold your principal residence, you were allowed by the tax law to exclude up to $125,000 of your gain. Thus, in our example, although you made $200,000 in profit, after excluding the $125,000, you would only have to pay tax on $75,000 ($200,000- $125,000).
Many readers will no doubt ask: why is he writing about this old law? Can’t we just take up to $250,000 (or $500,000) when we sell our principal residence? Isn’t that what the new law says?
The answer is that the new tax law allows the principal home seller to exclude up to $250,000 of gain ($500,000 if married and filing a joint tax return). But what is “gain”? Gain is the profit you have made, taking into consideration the tax basis of your property.
Now let’s go to the original question. When the writer sold her property in l990, she made a profit of $450,000 ($500,000 - $50,000). She took advantage of the once-in-a-lifetime exclusion of $125,000, leaving her with a profit of $325,000. However, she rolled over this profit by purchasing a condominium which cost her $300,000. As noted, she paid capital gains tax on the $25,000 difference.
Now, she wants to sell the condominium for $450,000. At first blush, one would think that since she purchased it for $300,000, she would make $150,000 on the sale, and thus under the new law would be able to exclude all of the profit.
Unfortunately, that’s not the case. Although she purchased the condominium for $300,000, keep in mind that this was all “rolled over” dollars. She had earlier avoided paying capital gains tax on the $300,000 profit she had made. Thus, despite the purchase price, her basis in the condominium is zero. ($300,000 - $300,000). If she sells the property for $450,000, all of this is gain. If she is not married (or files a separate tax return) she can only exclude up to $250,000 of this gain and will thus have to pay capital gains tax on the $200,000 difference.
It should be noted that I have ignored for this discussion various closing costs and real estate commissions which should be included in the calculations, so as to reduce her actual capital gains tax obligation. It should also be noted that currently, the capital gains rate is 20 percent, whereas in l990 when she sold her first property, the rate was 28 percent.
Thus, while our writer will have to pay approximately $40,000 in capital gains tax to the Internal Revenue Service, there is some consolation. Had the older laws not been in existence, she would have paid a lot more back in l990, and would probably not have been able to afford the new condominium – on which she also made a nice profit.
However, for readers who took advantage of the old roll-over (and even the once-in-a-lifetime exclusion) many years ago, it is important to dig out your old tax returns and calculate exactly what your current tax basis is. Too many people will get a shock if they get a letter from the IRS telling them that they owe a lot of money on the sale of their principal residence, if they do not report the true tax basis of their home.