Capital Gains Exemption

Capital Gaines Exemption

The Capital Gains Exemption, also commonly known as the home owner’s exemption, was created by Congress passing the Taxpayer Relief Act of 1997. The Bill added Internal Revenue Code 121 Principal Residence Sale Tax Exemption. IRS publication 523 is a great reference if you need more information on Homeowners Capital Gains Exemption. This exemption is one of the big tax breaks you get from owning real estate.  

To Qualify for a Homeowners Capital Gains Exemption:

1. The home must be your primary residence.

2. You must have occupied the home as your primary residence for at least two years within the past five years. The two years need not be continuous.

For a single person, the Capital Gains Exemption is up to $250,000. For a married couple, only one spouse need hold the title, but to qualify for the $500,000 exemption both spouses must meet the two-year occupancy test and file a joint tax return.

Long-Term Capital Gains Tax rate is 15%-20% for the Federal taxes, plus 7.35% to 13.3% for California state taxes. In California, there is no special tax rate for capital gains, it is treated like ordinary income.  If you held your investment for less than a year, then the gain is considered Short-Term. Capital Gain tax for Short Term Capital gains is 22%-37% and taxed at your federal income tax rate plus again the California state taxes of 7.35% to 13.3%.

If you owned and occupied your primary residence immediately for two years you qualify for the exemption. In theory, you could rent your home to tenants for up to three years afterward before losing your principal residence sale exemption eligibility. When you sell, you can do whatever you want with the proceeds.

Many homeowners think they have to own their homes at least five years before qualifying for this great tax break- that’s incorrect. You can qualify for the exemption in just two years if you move into your home immediately. You can utilize the capital gains exemption once every two years and there is no limit for how many times it can be used in one’s lifetime, but keep in mind, that it only works for your primary residence, and does not work for Investment Property. A 1031 Exchange is probably your best option to avoid capital gains tax for your investment properties.

FAQ

Q: We are a married couple that qualify for home owner’s exemption and our Capital Gain on the sale of our house was $700,000- since it is larger than $500,000 what happens?

A: The first $500,000 is tax-free. You would be taxed on the remaining $200,000. 

Q: I own two homes, one in New York and one in Los Angeles. From 2009 to present I have been living 7 months a year in Los Angeles, and the rest of the year in New York. I am leaving the US and want to sell both homes. Can I use the capital gains exemption on both homes? Does the capital gains exemption apply for second homes or vacation property?

A: No, the capital gains exemption only applies to your primary residence. The IRS considers whichever property you spend more time at as your primary residence, however, you can declare either property your primary residence for tax purposes- so long as you don’t claim them both. One idea would be to sell your primary residence with the capital gains exemption, wait two years and then sell the other as your new primary residence.

Q:  Emily bought her house three years ago. Emily marries James in June 2012. She then sells her home in June 2013 for a gain of $300,000. Do Emily and James qualify for $500,000 capital gains exemption?

A: No, Emily and James are married, however only one of the couple has lived in the property for 2 years, James has only lived there one year. Emily can exclude up to $250,000 of gain and James can exclude nothing. It might be best for them to wait 1 year and then sell depending on the size of their gain.

Q: Are they any exceptions to meeting the 2-year requirement?

A: Yes, if you were sent overseas to serve the military or work for the government, disabled, or meet certain requirements. Take a look at IRS publication 523

Q: I own a home as a Tenant in Common with a friend. Do we each get to claim a homeowners capital gains tax exemption of $250,000 if we meet all the requirements?

Q: Amy bought her house five years ago. She moved in for a year, then rented it for 3 years, and moved back in last year. While she was renting the house she deducted $10,000 a year in depreciation. Now she is selling the house and has a gain of $200,000. Does Depreciation recapture affect her capital gains exemption?

A: Yes. Since Amy rented her house and took depreciation this is going to change the total amount that she can exempt from her capital gains exemption. You take the total number of years the property was rented (3 years) and divide it by the total number of years the property was owned (5 years) to get a ratio of how long the home was owned versus rented (60%). You subtract from the capital gain the deductions for depreciation ($200,000-$30,000= $170,000) and multiply that by the ratio ($170,000 *0.6= 102,000). Finally, you subtract from $170,000 the $102,000 to get your total capital gain exemption which in this example would be $68,000.

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