The tax treatment of gain on the sale or exchange of a principal residence has
changed drastically as a result of the Taxpayer Relief Act of 1997. Note, however, that you still may not deduct any losses suffered on the sale. The new home-sale gain exclusion rule replaces the "rollover" rule that allowed homeowners to defer paying tax on the gain on the sale of a principal residence if they reinvested the sale proceeds in a new home of at least equal value within two years of the sale. The new rule also replaces the once in a lifetime $125,000 exclusion that was available for taxpayers age 55 and over who sold their homes. The following analysis is a summary of the law as amended by the 1997 Act.
Under the new home-sale exclusion rule, you may be able to exclude a portion, or possibly all, of the gain realized from the sale of your home if your home met the principal residence rules. During the five-year period ending on the date of the sale you must have owned and used the property as your principal residence for a period aggregating two or more years. You need not have lived there continuously to qualify. You may use the exclusion as many times as you wish, provided the eligibility requirements are met, but generally no more frequently than once every two years.
The amount of the exclusion is generally limited to $250,000 for single individuals and married individuals filing separately. The exclusion is increased to $500,000 in the case of married couples filing a joint return, where at least one spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse is ineligible for the benefits because he or she excluded gain on the sale or exchange of a home under the new provision within the past two years. If a taxpayer marries someone who is ineligible, the taxpayer generally remains eligible for a maximum exclusion of $250,000.
If you fail to meet the ownership and use requirements due to a change in place of employment, health, or other unforeseen circumstances, you may exclude a fraction of the $250,000 ($500,000) amount.
Special rules apply in determining ownership and use if you are receiving out-of-residence care, inheriting property from a spouse, transferring property pursuant to a divorce, or disposing of property where the rollover rules applied.
The new exclusion rule also generally applies to the sale of a remainder interest in a principal residence, if all the other requirements are met. Thus, you may retain a life estate in your home while selling the remainder interest.
The new exclusion rule requires gain recognition to the extent of any depreciation taken after May 6, 1997, for the rental or business use of your home. In such cases, the gain will be subject to a special capital gain rate of no greater than 25%.
The home-sale gain exclusion provision generally applies to sales of a principal residence occurring after May 6, 1997. You may elect, however, not to have the new exclusion provision apply to any sale or exchange (in such cases, gain recognition generally is required and the prior law rollover and one-time exclusion provisions cannot be applied).
You may elect to apply the former rollover and one-time exclusion rules, and not the new home-sale gain exclusion rule, to certain transition period sales occurring: (1) before August 5, 1997; (2) after August 5, 1997, if it is pursuant to a contract which was binding on August 5, 1997; (3) after August 5, 1997, if gain would not be recognized under the former rollover rule because a replacement residence was acquired on or before August 5, 1997 (or pursuant to a binding contract in effect on August 5, 1997).
If you owned a residence on August 5, 1997, and sell or exchange it within two years from such date but fail to meet the two-year aggregate ownership and use tests or satisfy one of the qualifying conditions for proration (e.g., change in place of employment, health, or other unforeseen circumstance), you may prorate the exclusion amount based on the period during which you owned and used the home.
With the repeal of the rollover rule, you are no longer required to purchase a replacement residence within strict time limits in order to defer (rollover) any gain realized on the sale or exchange of your home. You are also no longer required to split the basis in your home between that portion used as a principal residence and the portion used for rental or business purposes as was required under the rollover rule. The present exclusion rule is a significant improvement over the age 55 or over exclusion, not only because it is available to taxpayers of all ages and allows a greater exclusion, but because it can be used repeatedly and one spouse is not denied the benefit of the exclusion just because the other spouse had elected to exclude gain on the prior sale of another residence.
There is a downside to the repeal of the rollover rule if you have a gain in excess of $250,000 ($500,000 if married filing jointly) when you sell your home. Instead of being able to defer the gain by buying a more expensive home, as under prior law, you will now be liable for income tax on the excess gain in the year of sale. In these circumstances, application of prior law would result in a lower tax liability, provided you are able to apply one of the transition rules discussed above. The Taxpayer Relief Act of 1997, and later amendments thereto, enacted another provision that makes the gain recognition more palatable. If you owned your home for at least 12 months, the excess gain will be subject to a significantly lower capital gain rate of 20%.