More than any nation on earth, the United States seeks to encourage home ownership for its citizens. Back in the 1950’s, a conscious decision was made to promote home ownership as a method to create a prosperous middle class and further social stability. The ownership of one’s own home has since become a standard American dream for both citizens and newcomers to this nation.
The methodology to encourage this ownership has been the creation of appropriate road networks to allow emergence of suburbs, various financial packages for home buying made available for first time home buyers (FHA Loans) and loan packages made available for veterans of the military forces (Veteran’s Loans.)
But by far the greatest motivator has been the tax treatment of homeowners which essentially has the United States government giving tremendous tax advantages to those who purchase their own home.
This article shall briefly list the major advantages. The reader is advised to get both legal and tax advice before taking specific action predicated on this article.
THE BASIC LAW:
The government grants two tremendous tax benefits to the owner of a home. First, home loan interest is deductible under most circumstances. Second, a capital gain on appreciation of the home value when the home is sold is tax free under most circumstances.
THE 1997 TAX LAW
The 1997 Tax Law for Home Sellers was approved by Congress on May 7, 1997, and signed by the President on August 5, 1997. California followed shortly thereafter, so we have the same rules for both Federal and California. While the law can become quite complex, the essential law is not and provides that in addition to being able to deduct the interest on home loans (thus save essentially about one third of the cost of the interest payments by deducting all interest paid from your income for tax purposes) one need not pay capital gains income tax on sale of one’s residence even if one was not over fifty five years of age as under the previous law and with no need to invest the gains in the next home, as previously. That tax savings is now available to all people, limited only as provided below:
HOME SELLER TAX RULES
Effective May 7, 1997, if you meet 3 tests, you qualify. It does not matter what you do with the money. You do not have to buy a new home. There is no more rollover requirement. The test to allow no capital gains is:
1. "USE TEST:" Did you live in the property as your principal residence for any two year total period within the last five years looking back from the date of sale? The two years do not have to be consecutive periods - it might be one day at a time, as long as it totals two years. You do not have to own it for five years; merely own it for two years within the last five years.
2. "OWNERSHIP TEST:" Did you own the property for a two year total period within the last five years? For a married couple, only one spouse needs to be an owner for both to qualify, if both spouses meet the Use Test.
3. "BEFORE TEST:" Did you do a tax free sale within the last two years?
EXCLUSION AMOUNTS
A single person can exclude $250,000 of profit;
A married couple filing a joint return can exclude $500,000 [even if only one spouse meets the two out of five year ownership requirement, as long as they both lived there two years].
Note that a strict reading of the law would allow a single person to sell his home today, get married on New Years Eve, and file a joint return excluding $500,000, as long as either spouse owned the second home for at least 2 years, both spouses lived in the residence for two years, and neither sold a home tax free within the last 2 years.
This rule can be used every two years.
Unlike the old law, now the property can be rented for several years and then sold.
If the home generates capital gains above this amount, you pay the tax on the excess.
Assume Mr. X is married and bought his home 20 years ago for $70,000. If he sells it for $800,000 his profit is $800,000 - 70,000 = $730,000. If this was a stock sale, he would end up paying capital gains on 730,000 or about 150,000, depending on his other tax situation.
With a residence, this gain is reduced by $500,000 since he meets the requirements of the new law. His age and whether he buys a new home is irrelevant. He has to pay tax on $230,000 or about fifty thousand dollars, a savings of one hundred thousand dollars in capital gains taxes. When combined with the loan interest tax deduction, it is clear that the United States government gives tremendous incentive to invest your dollars into home ownership.
SPECIAL RULES
Even if one does not meet the three criteria above, one may still enjoy some of these tax benefits under the Proportional Rule:
If you do not meet the two year rules, there are three circumstances in which you may use the "reduced exclusion."
1. If you move due to:
change in place of employment,
change in health, or
special reasons not yet defined.
IF you meet one of those special circumstances, the exclusion amount is pro-rated. If you owned (or lived in) your home 16 months in the 5 years prior to the sale, you may exclude 66.6% (16/24ths) of the full exclusion amount ($250,000 / $500,000). If your profit is less than 66.6% of your $250,000 or $500,000 exclusion, nothing is taxable.
The Internal Revenue Service has sought to limit this exclusion. They claim that you may use the reduced exclusion only if you have not owned the home for 2 years, nor lived in it for 2 years. This means that if you have a rental property owned for many years, and have $250,000 of built-in profit, you and your spouse may not move in for 1 year and then sell and exempt all your profit (or half of the full exclusion amount), assuming that you meet one of the special circumstances allowing you to use the reduced exclusion. That position of the IRS may be challenged in tax court in the future.
Divorce Rule
What happens if you are the spouse leaving the family residence after a divorce? Previously, if a husband or wife left the residence (either while the divorce was pending or afterward) and it was then sold, technically he or she was ineligible to use the 2 year rollover rule: it was no longer his or her residence (even if he had left the home last month).
Now, the "out spouse" is eligible for these benefits if the "in spouse" is eligible, even if the "out spouse" has been out for many years if the sale is pursuant to the divorce or separation agreement.
Disaster Loss
If there is a disaster covered by insurance, it is taxed as a sale, rather than under the complex rules formerly applicable to such involuntary conversions.
Residence in Care Facility
Time spent in a licensed facility for a person who formerly lived in the primary residence for at least one year out of the last five but is incapable of self-care still counts as time in the primary residence. Thus, if Aunt Martha, age 78, has lived in the primary residence until she could no longer care for herself and went into the nursing home almost four years ago she still qualifies for the two of five years rule.
CONCLUSION
Occasionally one hears grumbles from Congress about eliminating the interest deduction from mortgage payments or reinstituting full capital gains for home sales. Such tax benefits have been termed, “welfare for the Middle Class.”
But every attempt to even consider introducing such a bill has met with a storm of protest not merely from all the homeowners, but from the building and construction industry who survives, to a large extent, on the huge demand for homes that such tax treatment generates.
It is unlikely in the extreme that the above law will alter in a negative sense and the investor, attempting to decide whether to invest money in stocks or a home, must realize that the tax advantages of home ownership are so massive that few other investments can even come close. When one realizes that cash may be available from the equity line on the home and that interest paid on that equity loan remains tax deductible, it becomes clear that home ownership is by far the best initial investment that most people can make in the United States. The reader is invited to read the basics of purchasing such property in our web article, Real Estate Ownership and Transactions in the United States for a fuller discussion of the method of purchasing property that would qualify for this tax treatment.