For Some That Big, Tax-free Gain May Not Be There After All
When I was a boy my dad bought the family home with his Korean War veteran’s benefit and the savings he’d accumulated working lots of long hours. I don’t know whether, back in the days of black and white television and corded telephones, he was eligible for all the tax breaks today’s homeowners have grown accustomed to but I certainly hope so.
In this modern age one of the very best tax breaks is a homeowner’s ability to exclude from income up to $250,000 ($500,000 for those married and filing jointly) of the gain realized when he sells his home. But like everything else tax related, this is trickier than it seems and the unprepared can get hit with a tax bill they never expected. Here are two ways that might happen to you.
The first trap is thinking that just because you own a home you automatically qualify you for the full exclusion. You don’t. For one thing, you can’t claim the exclusion for the current sale’s gain if you claimed it for selling a different home less than two years previously. After that, at a minimum you’ll have to pass both the “ownership test” and the “use test”.
To pass the ownership test you must have owned the house for at least two of the five years preceding the sale. That said, there are lots of rules about and exceptions to this requirement. For example, you can add together a few months here and a few there to make the two required years. And in some circumstances temporary absences might not be counted against you, not even if you rented out your home while you were gone. Other exceptions are made for the mentally and physically challenged, for those moving to a new job, for soldiers, and more.
The use test requires that you actually used the home as your main residence for at least two of the five years before you sold it. So right off the bat that vacation home you built during the boom years won’t qualify for the gain exclusion. What’s more, the two year period used to meet the use test need not be the same period satisfying the ownership test.
Bottom line: If you didn’t meet all three of these requirements at the time of sale then there’s a capital gains tax bill heading your way.
Even if you pass those threshold requirements there still may be a second trap waiting to ensnare you. Consider, for example, a hypothetical taxpayer named Angela, who for all the ten years she has owned her home has run a small consulting business. During that time she has maintained a home office which she regularly and exclusively used for her business. Angela has, therefore, each year properly reduced her earned income by taking a total of $50,000 ($5,000 a year) in home depreciation deductions.
Suppose further that Angela bought her home for $200,000 and after a good ride sells it for $450,000, thereby realizing a $250,000 gain. She promptly claims her exclusion, pays no tax whatever on the gain, plows most of the cash into her business, and takes a much needed European vacation. But after she returns a month later, all rested and refreshed, a letter from the IRS arrives demanding Angela pay $15,000 in income taxes on the sale.
How did this happen? It’s called recapture income and it has stung many a seller of appreciated but depreciable assets.
Depreciation deductions are allowed because the business asset in question is assumed to be worth less every year than it was when you bought it. The loss of value is treated like a deductible business expense. The deductions in our example reduced Angela’s ordinary income, which meant she paid less ordinary income tax.
But as it turns out this depreciable asset (the house) wasn’t worth less every year. It was worth more. So those deductions weren’t expenses she actually incurred in operating her business. Angela didn’t do anything wrong. It just turned out that her depreciable asset was worth more, not less. The result: She has to “recapture” those deductions and pay the tax on them.
So instead of being allowed to exclude her entire $250,000 gain Angela can exclude just $200,000. The rest is taxable. Ouch.
Worse still, the remaining $50,000 doesn’t get the favorable long-term capital gains tax rate. Angela is recovering reductions in ordinary income, after all, so she has to pay the much higher ordinary income tax rate. At 30% that gave her a very unexpected $15,000 tax bill. Double ouch.
Whenever someone sells something to someone else the ancient maxim of caveat emptor surely applies. “Buyer beware” just makes good sense. But in this age of ever increasing tax complexity it’s clear that sellers should be at least as cautious. Caveat vendit, everyone.
 In the right circumstances, you might qualify for some fraction of the maximum exclusion even if you can only muster a portion of the two year period.
 This can happen during a conversion of apartments to condominiums.
This article is for informational purposes only and does not constitute legal advice. You should consult a qualified attorney before taking any action.