Using the Taxpayer Relief Act of 1997, home-sellers can exempt up to $500,000 of their net gain from capital gains taxes. Learn how to use this tax exemption to your benefit and whether you should consult a tax attorney to maximize your efforts.
With the housing market booming, many homeowners are looking to capitalize by selling to the highest bidder. Qualified sellers may be happy to learn that they can reduce or even eliminate the capital gains tax on the sale of their home, thanks to the Taxpayer Relief Act of 1997. The Relief Act guarantees a tax exemption on up to $250,000 of capital gains for single homeowners and up to $500,000 for married couples filing jointly.
However, there are a few caveats to qualify for this exemption. Below is a quick guide to the Taxpayer Relief Act of 1997, who qualifies, alternatives, and who should consider hiring an experienced tax attorney to navigate these options. Additionally, we will discuss alternative options for those who do not qualify for the Taxpayer Relief Act of 1997.
Understanding the Taxpayer Relief Act of 1997
We must first define a couple of terms.
The net gain refers to the homeowner's selling price minus the cost basis or the purchase price plus adjustments (more on adjustments later). A capital gains tax is a type of tax on the net gain earned on the sale of an asset.
So how do you reduce or eliminate your capital gains tax for the sale of your home? The Taxpayer Relief Act of 1997, which works as follows:
The first $250,000 in profits is tax-exempt for single homeowners, up to $500,000 for married homeowners filing jointly.
The property sold must be listed as the seller's primary residence for at least two years within a five-year period prior to the sale of the home.
The seller may only use this taxpayer relief once every two years.
Suppose Paul buys a home at $300,000, and the property rises in value, allowing Paul to sell it at $600,000. That's a $300,000 net gain that could be subject to capital gains taxes. If Paul is a single homeowner, he can exempt $250,000, and $50,000 of the net gain would be subject to capital gains taxes.
However, if married and filing jointly, he can exempt up to $500,000. Let's suppose Paul is married and filing jointly. He's lived in this home with his spouse for at least two years in the past five years and has not used this tax exemption within the past two years. Under these circumstances, Paul and his spouse would owe no capital gains taxes as the $300,000 net gain falls below the $500,000 threshold.
Simple enough, right? That said, many circumstances blur the line as to whether you can take advantage of this tax exemption. For example, how do you know if your property qualifies as an IRS primary residence? Can your rental property qualify for this tax exemption? What happens if your spouse is deceased? Can you still use the tax exemption as a married couple?
We will tackle these questions below.
Does my property qualify as a primary residence?
To qualify as a primary residence, the home must be occupied by the homeowner for at least two years. However, you need not live in the home for two consecutive years. Rather, you must occupy the home as a primary residence for two out of five years prior to the sale.
For married couples, both must live in the home for two years, but only one of them needs to have owned the home for at least two out of five years prior to the sale.
What about second homes and rental properties?
If the property is used as a rental property, you may still be able to use this tax exemption if the property has been used as a primary residence for two out of five years prior to the sale. So, for example, if Paul and his spouse were to live in the property for one year, then rent the property out for three years, and then move back to the property for one year, they would qualify to use this exemption.
However, if Paul and his spouse have two properties and wish to sell both, only one of the properties may qualify for this tax exemption. This is because the Taxpayer Relief Act of 1997 may only be used once every two years. Thus, Paul and his spouse would need to wait two years to sell this second property using this tax exemption.
What if one of the spouses is deceased?
In the case of a deceased spouse, the surviving spouse can often get the full $500,000 tax exemption if the home is sold within the first two years of the spouse's date of death and if the surviving spouse hasn't remarried.
If the surviving spouse sells the home after this two-year period, the surviving spouse can still exempt $250,000 from capital gains taxes but not the full $500,000 they would've qualified for as a married couple.
There are further aspects to consider depending on your state. If you fall under this category, you will benefit from consulting a tax attorney to navigate your options.
Reducing Capital Gains by Increasing Costs
In addition to the Taxpayer Relief Act, homeowners can offset some of the profits by increasing the fees and expenses associated with the purchase, improvements, and additions to the home. Remember the "adjustments" we mentioned earlier? Certain investments made into the home can be used to offset net gain by increasing the cost basis.
For example, let's assume Paul and his spouse sold their property for $850,000 after purchasing the home for $300,000. Paul and his spouse would have a $550,000 profit, of which $500,000 are exempt from taxes, leaving $50,000 in taxable net gains. However, if they invested $50,000 in converting the garage into an extra room, those expenses can offset the capital gains.
Repairs, however, are excluded and may not be used to offset capital gains. In cases such as these, it's best to work with a tax attorney that can help you navigate your options for the best possible outcome.
You can also refer to Publication 523 to see if your home project qualifies as an improvement or addition.
Opting for a 1031 Exchange
If you do not qualify for the Taxpayer Relief Act of 1997, do not fret. You may still qualify for alternative options and save money in capital gains taxes on your real estate property.
The 1031 option is excellent for business owners and investors selling one property and reinvesting the gains into a similar property. The property subject to a 1031 exchange, however, may not be for personal use. The real estate property purchased through a 1031 exchange must instead be used for business or investment. Thus, this is a better option for businesses and investors, including corporations, individuals, trusts, LLCs, etc.
However, a property obtained through a 1031 exchange does not qualify for the Tax Relief Act of 1997 in any future sales of the property.
Do I Need a Tax Attorney?
Several cases necessitate the services of an experienced tax attorney to help you navigate your options and ensure you can achieve the maximum tax exemption that you qualify for. Vadam Law recommends the services of a tax attorney if you fall under the following groups:
You are divorced or separated and wish to sell a home that both spouses jointly owned.
You or your spouse are in the military.
You or your spouse are in a nursing home, and no longer live at the subject property.
You want to use the Taxpayer Relief Act of 1997 to exempt profits made on the sale of an investment property that has been used as a rental property or vacation home.
You want to use a 1031 exchange to use the earnings of a property toward the purchase of a similar property.
You run a business from home, which blurs the line between primary residence and business.
If you’re ready to sell your home and would like more information about navigating tax exemptions, contact one of our tax attorneys.
To learn more about VAdam Law and schedule a free consultation, visit our online scheduling portal or call 24 hours a day at (954) 451-0792.