Thanks to the big appreciation in home prices, many homeowners are making a bundle when they sell. What's more, most will get to pocket those profits tax free -- up to $250,00 if single and up to $500,000 married -- as long as they have lived there for at least two of the past five years, courtesy of a 1997 law excluding most capital gains on principal residences from taxes. Still, a small, but growing, number of upper middle-class and affluent homeowners in pricey markets along both coasts are beginning to exceed the generous limits of the law and will have to pay capital gains taxes on the excess, according to tax and real estate experts. The tax of 15% or 5%, depending on the seller's tax bracket, can be reduced or eliminated with good tax planning and careful record keeping. For some taxpayers, the tax can even help wipe away any large, painful stock-loss carry forwards of the past several years. W.G. Spoor of Spoor Doyle & Associates CPA in St. Petersburg, Fla., says he recently worked with one client who bought a two-bedroom, two-bath condominium in Manhattan near Central Park in the late 1990s for $200,000. The man recently sold it for $700,000. "He was strictly buying in the right place at the right time," says Spoor. That was the good news. The bad news was that he made such a big profit, not all of it was tax free. The tax calculations go like this: His basis (the original price plus expenses used in calculating capital gains) in the property was the $200,000 he paid for it, plus $50,000 for remodeling the kitchen. That $250,000 was subtracted from the $700,000 sales price for a gain of $450,000. After subtracting his $250,000 capital gains exclusion for single taxpayers, the seller had $200,000 in taxable gains. For most people in this situation, those in the highest tax brackets, the capital gains rate would be 15%.
Linda Goold, tax counsel for the National Association of Realtors, or NAR, said the association is aware that rapid price appreciation in a small portion of the nation's housing stock is causing home sellers to exceed the 1997 exclusion threshold. "We know that it's a problem, that it's out there," she says. "We were disappointed when Congress initially passed the law, that they didn't index it for inflation." In the first quarter of this year, 5.4% of homes sold nationwide were priced at more than $500,000 and 25.8% cost between $250,000 and $500,000, according to Walt Molony, an NAR spokesman. It's impossible to tell, of course, how many sellers exceed the exclusion thresholds without knowing the basis in the homes. Many people who are near the threshold can avoid going over it simply by keeping good records on their homes for the purpose of establishing the tax basis. Mark Luscombe, principal analyst at tax-law research company CCH, says that basis is what the homeowner paid for the property, the selling costs and capital improvements. The Internal Revenue Service does not consider routine maintenance like painting or replacing carpeting to be an improvement. Rather, it is anything that extends the life of the home, such as a new roof, electrical system, heating system, siding, or a new fixture like a bathtub or toilet. This also includes new windows, major landscaping such as trees and in-ground swimming pools. Spoor, the Florida CPA, has worked with one couple who are preparing to sell a waterfront home they bought decades ago for $70,000 in a neighborhood where houses now go for $1.4 million and up. They plan to buy a less expensive home and use the balance to help finance their retirement. "We've tried to put together a list of all the improvements," he says, acknowledging it will be difficult for them to avoid paying some taxes. "We try to get the basis as high as we can."
Luscombe says it best: If possible, keep a permanent file and update it regularly, as he does: "I just keep sort of a running tab on my basis." All records should be kept for at least three years after the home is sold. Henry Strohminger, president-elect of the Baltimore Board of Realtors, where home prices have experienced double-digit appreciation for the past three years, tells all his clients to keep good records on their homes. "It's the biggest purchase people will make in their lifetime," he says. "Why shouldn't they keep good records?" Michael Eisenberg, CPA, PFS with Michael Eisenberg Accountancy Corp. in West Los Angeles, says he reminds clients every year to monitor the basis in their homes. With real estate prices continuing to soar this year, several clients have exceeded the exclusion limit when they sold. One married couple with two children, one in college and one in high school, wanted to move down to a less expensive home from a house on a large piece of land that was costing them dearly to maintain and use some of their gain to help defray college expenses. In some cases, Eisenberg has advised clients who took big stock losses in the past few years and are still carrying them forward to apply them against the gains that exceeded the home exclusion limit. "Now those losses will be offsetting the gains on the house," he says. "It erases the burden of the losses from years ago." Eisenberg offers one note of caution for taxpayers who've owned their homes since before 1997. If they owned at least one other house before the one they're in now, they might have to take into account some aspects from the previous law, which required homeowners to carry their gains with them from home to home before finally taking one lifetime exclusion.
The upshot, he says, is "potentially you could have more gain built up than you thought." They might want to consult a tax professional before selling. But Eisenberg doesn't hesitate to encourage clients to go for their $250,000 or $500,000 in tax-free money. After all, the law allows them to buy another house and do it again. "Avail yourself of this wonderful, wonderful law," he says. "This is a good one."