Betsy Flynn, a widowed empty nester, sold her four-bedroom family home last December and bought a dream cottage without thinking much about the tax consequences.
The hot housing market convinced her to cash in her major asset after back-to-back bear markets drained her retirement savings and left her fearing for her financial security.
Had she sold the house when her husband John died in 1999, the home sale would have been simpler from a tax standpoint, but taxes weren't foremost in her mind then and she wasn't ready to move on either.
Under the 1997 Taxpayer Relief Act, couples who sell a house owe no capital gains if they have lived in the house at least two of the last five years and have made no more than $500,000 in profit. If one spouse dies before the house is sold, the other spouse can exclude only $250,000 in capital gains profits.
"Being able to exclude a large gain entirely from your income may prove to be an even greater tax advantage long-run than the yearly itemized deductions for mortgage interest and property taxes," says tax lawyer John Roth of tax publisher CCH Inc. "The family home is the largest asset owned by many families, and a profitable sale of a longtime family residence is often one key to financing retirement."
Tom Pudner, manager of personal financial planning at KPMG's Washington national tax office, says good record-keeping is still critical because, even though the home sales change was sold as a way to simplify the tax code and record-keeping, it hasn't worked out that way for many people.
Your taxes will be simple if this is the first house you've sold and you sold it for less than a $250,000 profit, or $500,000 for couples: Your lender won't even send you or the Internal Revenue Service a 1099-S form reporting the sale because the money isn't taxable.
But the current housing boom makes it easy to go through that $250,000-a-person ceiling even on sales of modest homes owned for more than a few years. That's where the record-keeping comes in.
The rules before May 1997 required a lifetime of record-keeping because homeowners had to document any home improvements they made and any capital gains tax they deferred from a home sale in rolling over profits into a house of equal or greater value.
With the new rules, homeowners must know how much of the sales price is profit to see what tax, if any, they owe. That means:
- You must account for all the home-sale gains you deferred under the old rules.
- You need proof of what you spent on major improvements to the house you're selling. Routine maintenance doesn't count.
Fortunately, Betsy Flynn kept an "old house" journal containing all contracts, bills and canceled-check copies documenting the $200,000 in major improvements she and John made to the family home over 25 years - improvements that include central air conditioning and ductwork, modern bathrooms, new landscaping and a kitchen-family room addition with a walk-out deck.
The upshot? Flynn owes no capital gains tax on her $500,000 sales price since the family bought the house for $200,000 and made $200,000 in improvements, cutting her profit to a tax-free $100,000.
Had she been above the $250,000 threshold, the profit above that amount and any capital gains tax owed is reported on Form 1040 Schedule D, Capital Gains and Losses.
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Homes aren't a bottomless tax break, however:
- You cannot claim a tax write-off if you sell your house for a loss.
- You don't get a $250,000 tax-free profit if you move before living in a house two of the last five years because you find a house you like better. A job change, serious illness or other "unforeseen circumstance" requiring relocation may win a partial or full exclusion on any profit prorated by the length of time you lived in the house.
- You must subtract from the $250,000 tax-free profit any depreciation claimed for a home office or rental apartment. Depreciation claimed since 1997 gets "recaptured" when you sell the house, and the amount is taxed at 25 percent, whatever your tax bracket.
On the Net, IRS Publication 523 "Selling Your Home," is posted at www.irs.gov. The IRS toll-free phone number to order it is 1-800-TAX-FORM (1-800-829-3676).
Keep a journal
Keeping a journal of your home's major expenses is a wise idea, whether the house is old or new and whether you're selling or staying put:
- From a tax standpoint, the $250,000-a-taxpayer exemption for home sale profits, or $500,000 for couples, was supposed to eliminate paperwork. But it hasn't.
- Even modest homes owned for more than a few years may see a hefty appreciation in price in today's hot market that could push you above the tax-free profit total and subject you to capital gains taxes unless you can document major improvements you made to the house on top of the price you originally paid.
- Unless it's your first house you're selling, you have to document all the profits you rolled over from previous homes under the old federal tax rules into the house you're selling now to show the Internal Revenue Service that you don't owe capital gains tax.
- Prospective buyers will expect information about when additions were put on and major improvements were made.
- Even if you're not selling the house now, a house journal that records your appliance dealers, contractors and warranty information is a handy reference for repairs or future work. Future owners will appreciate the references, too.