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Avoid Captial Gains Tax, Property Tax Law

Wednesday, December 27, 2006 - Article by: Lender411 Member

Most of you know that in 1997 a new law was created that allows you to buy and sell a home and keep up to $500,000 tax-free, every two years, repeatedly.

If you owned and lived in your primary residence for 2 of the last 5 years, you can keep up to $250,000 of capital gains absolutely tax-free. If you're married, the limit is $500,000. You don't even have to file a form with the IRS. It is quite simple.

Did you know that if you lived in your home LESS than 2 years, there is still a way to entirely skip the capital gains tax? You can always claim one of "The Exceptions."

The Three Exceptions

If you owned the house and lived in it for less than 2 years you still might qualify to pro-rate your tax liability if you sold because of one of the following reasons:


A sale will be considered as related to "a change in health" if the primary reason is related to:

(i) a disease, illness, or injury of
(ii) the taxpayer, the taxpayer's spouse, a co-owner of the home, a member of the taxpayer's household, or certain close relatives.

The "certain close relatives" means you can move in order to care for sick family members. Also, if a physician recommends a change in residence for health reasons, that will suffice.


A home sale will be considered as related to "a change in employment" if, during the ownership and use of the home,

(i) the taxpayer, the taxpayer's spouse, a co-owner of the home, a member of the taxpayer's household moves because their new place of employment is at least 50 miles farther from your home than the former place of employment was.


A sale will be considered as occurring primarily because of "unforeseen circumstances" if any of these events occur during the taxpayer's period of use and ownership of the residence:

--divorce or legal separation,
--becoming eligible for unemployment compensation,
--a change in employment that leaves the taxpayer unable to pay the mortgage or reasonable basic living expenses,
--multiple births resulting from the same pregnancy,
--damage to the residence resulting from a natural or man-made disaster, or an act of war or terrorism, and condemnation, seizure or other involuntary conversion of the property.
--Any of the first five situations listed must involve the taxpayer, spouse, co-owner, or a member of the taxpayer's household to qualify.

If you still don't qualify, the IRS Commissioner has the discretion to determine other circumstances as "unforeseen."

So now you have determined that one of the Three Exceptions applies to you. Now you have to pro-rate. For more info, examples, and how to pro-rate, please see the website link at the bottom of this newsletter.

Frequently Asked Questions About Capital Gains on the Sale of Your Residence

Are losses on the sale of a residence deductible?
No. Taxpayers still cannot deduct losses on the sale of their residence.

What are the capital gains rates?
Capital gains rates are based on an individual's taxable income.

Do the two years in this law have to be consecutive?
No, you can live in the property for one year and rent for one, then live there one year, etc.

What if I convert my primary residence to a rental for more than three years, can I take advantage of the tax exclusions?
Unfortunately not. The residence is no longer deemed a principal residence. You would be required to occupy it again for two years. However, for less than three years, keep reading.

If I convert my primary residence to a rental, how long does it have to be rented to qualify for a 1031 tax deferred exchange?
There is no definitive answer in the tax code that directly addresses this question. Under 1031, you may defer capital gain taxes when like-kind properties, which are "held for investment," are exchanged. Many tax and legal advisors believe that at least one year of ownership is a reasonable minimum time frame. The owner must be able to support the fact that the home was legitimately converted to a rental that was "held for investment." For more information on 1031 Exchanges, please request my previous newsletter on the topic.

What does this all mean?
Home owners can downsize without a huge tax penalty.

The potential exists for tax-free dollars to be used for the purchase of investment property.

Convert a vacation home into a primary residence and take advantage of the tax exclusion in 2 years.

Serial homebuyers--you can buy and live in a "fixer home" for two years and keep the profit!

How can I avoid the capital gains tax on the sale of rental, investment or a vacation property?
Simply convert the property to a primary residence, use it as such for the appropriate period of time, and then sell it for a tax-free gain. It's a bit more complicated, but you can read more about the rules for tax-free treatment on the gain of a principal residence by clicking the link at the bottom of the page. However, keep in mind that the Section 1031 gains are unlimited. The limits on the section of the tax code discussed in this newsletter are $250,000 for unmarried taxpayers and $500,000 for married taxpayers. It may be more beneficial to maintain your investment property depending on the size of your profits.

How do I convert my rental property to my primary residence to avoid the capital gains tax?
Move in there for two years. It makes no difference how much appreciation was built on the second property when it was a rental unit. Use the tax laws to your advantage.

Retirement Planning
Let's say you are thinking about retirement in the near future and you want to relocate to a "dream" community in another part of the country.

You are likely afraid that if you wait until retirement to sell your current home, buy a retirement home, and move to the retirement community, that the real estate market might push the cost of this retirement home out of reach.

So, you decide to purchase the property now and rent it out until you finally retire and move. You will still receive the gain exclusion on your current home when you decide to sell, and you can move into your retirement home and establish it as your new primary residence.

If the retirement area isn't as great as you first thought, all you have to do is meet the two-year residence test before selling the property to exclude up to $500,000 of the gain (save for any depreciation taken) and move on....again. You might have made a mistake with the selection of your retirement home, but at least you won't be paying any taxes on the gain.

Renting Your Existing House and Maximizing Your Appreciation

You own your home but you have decided to relocate. Make sure you have lived in the home you are in now for at least two years. Instead of selling this home to pay for the new one, rent it out.

You are now able to exclude up to $500,000 of the gain on the sale of the rental when you finally sell it while getting the same benefit in your new home. You may want to consider a cash-out refi or, preferably, a home equity loan, to help you purchase the new house, if necessary.

The only catch is you will have to close the sale of the rental within five years from the original date of purchase in order to avoid capital gains tax. Remember, the law says that the property must be used as a principal residence for at least two years during the five-year period ending on the date of the sale of the residence.

These are a few examples of how the gain exclusion rules can work for you. There are many others. Tax-saving opportunities exist for married people living apart in two separate homes, for people contemplating divorce, for the elderly who may have moved into an extended-care facility for a period of time, and any number of other different combinations. There is room to be creative, but, always, be SAFE and err on the side of caution.

Important Note:

Federal and state tax codes change frequently. This is general information, not tax advice. ALL OF THESE MATTERS ARE SUBJECT TO REGULATORY INTERPRETATION. PLEASE CONSULT YOUR TAX and LEGAL ADVISOR. This information is believed accurate as of the date of this newsletter, but is not guaranteed.

For more information on this topic, please visit the IRS website at:

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