For home sellers, times changed dramatically almost two decades ago in the tax-planning world.
But those 18-year-old reforms still catch some home sellers pleasantly by surprise.
No longer -- indeed not since 1997 -- do they need to buy a new house in the same year as they sell theirs to have any capital gains from the sale qualify as tax-exempt.
Under the post-1997 rules, homeowners each may receive a maximum of tax exemptions on the capital gains from the sale of a residence or $500,000 per couple, says Chad Smith, a wealth management strategist at HD Vest Financial Services, which is based in Irving, Texas.
To qualify for the tax break, the home sellers must each meet Internal Revenue Service-set tests of ownership and use, in other words, owning and using the home during two of the five years prior to the transaction.
“Keep track of any remodeling,” as those upgrades may be deducted when calculating the capital gains, Smith says.
Notably, however, maintenance costs may not be similarly deducted from a capital gains calculation.
The remodel of a kitchen or bathroom may be deducted from the capital gains calculation, as would an addition, the replacement of a roof, the paving of a driveway, the installation of central air conditioning or a rewiring of home. But the replacement of a water heater wouldn’t.
Homeowners should consistently keep track of their remodeling expenditures, so that they have them all in one place when it is time to report the gains on a sale, Smith says.
Sellers of rental residences who fail to meet the IRS’ use test, should consider buying another
real estate-related asset to avoid the capital gains tax and consider specifically what is known as 1031 exchanges, named after a section of the tax code that allows for the exemption, Smith says.
Under Section 1031 of the tax code, as interpreted by the courts, the seller of a non-residential property may execute a deferred exchange and within a set period invest in a like property, meaning U.S. real estate.
The 1031 option has grown in attractiveness for clients who want to extricate themselves from the hassles of renting real estate, who won't want to be landlords with tenants calling in the middle of the night, Smith says.
One other, often-forgotten caveat is that home sellers who expect to sell their residence for less than they paid -- at a loss – shouldn’t look to Uncle Sam for help.
“There is no relief in the tax code for those people, and we are seeing quite a bit of that these days,” says Mark Hyma, president of Professional Financial Services of San Diego, which uses HD Vest as its broker-dealer.
Miriam Rozen is a staff writer for Texas Lawyer who writes about financial advisors.
This story is part of a 30-day series on tax planning strategies.