Real Estate Capital Gains
Posted on November 3, 2008
Filed Under Capital Gains and Losses, Federal Income Tax
Sale of a Personal Residence
An individual may exclude up to $250,000 of the gain on the sale of a personal residence; the gain exclusion is $500,000 for joint filers. The gain exclusion may be used once every two years. Any gain in excess of the applicable exclusion amount is treated as a capital gain. A loss on the sale of a personal residence is not deductible.
To qualify for the gain exclusion, the taxpayer must pass an ownership and use test, that is, in the five-year period leading up to the date of sale, the taxpayer must have owned and used the property as a principal residence for at least two years. There is no requirement that the two-year period run consecutively but it must, in the aggregate, total 730 days (365 days per year x 2 years) in any five-year period. A vacation or a seasonal leave is a “short temporary absence,” and this type of absence counts as a period of use. Unfortunately, in federal income tax law, a difference in degree may be viewed as a difference in kind, and an absence of an entire year is too long a period of time for the label, “short temporary absence.”
In addition, even if the taxpayer is unable to meet the ownership and use test or the minimum two-year holding period, she can still claim a reduced exclusion if the primary reason for selling a residence is the occurrence of one or more of the following events:
- A change in employment whereby the distance between the location of the new job and the prior residence is at least 50 miles greater than the distance between the location of the previous job and the prior residence. If there is no previous place of employment, the distance between the job and the old residence must be at least 50 miles.
- A health problem of the taxpayer or taxpayer’s spouse, child, sibling, parent, or other qualified individual that forces the taxpayer to sell the home in order to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of a disease. However, a sale of a residence because a change in locale would be beneficial to the general health of a taxpayer or other qualified individual is not considered a sale for health reasons. In the eyes of the Internal Revenue Service, the primary purpose for such a sale is not to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of a disease, which fact makes the sale ineligible for the reduced gain exclusion.
- A “safe harbor” is provided for an untimely sale of a personal residence due to the occurrence of an unforeseen event–namely, an involuntary conversion or damage to the residence from a natural or man-made disaster or an act of terrorism. The reduced gain exclusion rules are also relevant if the unforeseen event is (1) a change in income that makes it impossible to meet household expenses, (2) death, divorce, or legal separation, or (3) multiple births from the same pregnancy and the person affected by the unforeseen event is the taxpayer, taxpayer’s spouse or other qualified individual, a member of taxpayer’s household, or a co-owner of the residence.
To invent a new phrase, these “reduced exclusion events” are the safe harbors that make it possible for a taxpayer to take advantage of the reduced gain exclusion; in technical terms, a reduced exclusion event is thought to result in a sale of the residence. The reduced gain exclusion is calculated by multiplying the maximum allowable exclusion ($250,000 for a single taxpayer or $500,000 for a joint filer) by a fraction with a numerator equal to the lesser of (1) the period of time the taxpayer owned and used the property as a principal residence or (2) the amount of time elapsed between the taxpayer’s prior use of the gain exclusion and the date of the reduced exclusion event. Depending on the measure of time used in the numerator, the denominator of the fraction is either 24 months or 730 days.
If the taxpayer doesn’t satisfy the safe harbor test, relief may be available under a facts and circumstances test. In this test, the Internal Revenue Service will determine the principal reason for the sale by looking at (1) events leading up to the sale, (2) the taxpayer’s financial responsibility to maintain the property, and (3) material changes in the taxpayer’s life that would affect the suitability of the property as a primary residence.
An allocation of the gain exclusion is not mandated if the home, as a single structure, doubles as a personal residence and a business or investment property. However, the gain exclusion is reduced for any depreciation taken after May 6, 1997 on the property.
A member of the military, the foreign service, or an intelligence agency who is on active duty away from home has the option to suspend the aggregate two-year holding period requirement for the sale of one residence. The suspension is good for up to ten years. But a taxpayer who acquires a personal residence in a like-kind exchange must own the property for at least five years to qualify for the gain exclusion. For more information on the gain exclusion for a sale of a personal residence, click on real estate capital gain (pdf file) and tax on real estate capital gains.
Sale of Subdivided Real Estate
Favorable tax treatment is also available for an individual who sells subdivided real estate. In particular, a gain on the sale of a subdivided lot or parcel in a tract of real estate may qualify for capital gain or loss treatment if the owner is a noncorporate investor, that is to say, the taxpayer is not a dealer in real estate or a C corporation. In other words, capital gain treatment on the sale of a subdivided lot or parcel in a tract of real estate is available only to a noncorporate investor. In brief, the corporate counterpart to our individual investor is likely in the business of buying and selling real estate; that is, in all likelihood the corporation is a dealer in real estate and any subdivided real estate in its hands is inventory, a noncapital asset according to the Internal Revenue Code. On the other hand, subdivided real estate in the hands of an investor is not viewed as inventory, which fact makes the property eligible for capital gain or loss treatment upon sale or exchange.
In particular, a lot or parcel in a tract of real estate held by a taxpayer who is a noncorporate investor qualifies for capital gain or loss treatment gain upon sale or exchange under the following conditions:
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The property is not, and has not been, held primarily and principally for sale to customers in the ordinary course of business. Moreover, at the time of sale or exchange of the property, the taxpayer must not have an inventory of real estate for sale to customers in the ordinary course of business. In short, the taxpayer cannot be a dealer in real estate.
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The property has been held by the taxpayer for at least five years. However, if the property is inherited or acquired by devise, there is no long-term holding requirement: capital assets acquired by such means are automatically assigned a long-term holding period.
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The taxpayer has not made substantial improvements to the property. There is an exception to this rule for expenditures that are necessary to make the property marketable. Improvements in this category–for example, expenditures for road installation, water, sewage, drainage, etc.–are not considered substantial improvements if the property is held for at least 10 years. The flip side: the taxpayer must not add the cost of these improvements to the basis of the property or take a deduction for the expenditures.
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If the property is one of the first five sold from the same tract of real estate, then any gain is a capital gain. But in the year the sixth lot (or parcel) is sold, the gain on the sixth lot and its successors will be taxed at ordinary income rates in an amount equal to 5% of the selling price; any remaining gain will be taxed at capital gains rates. Selling expenses for the sixth lot and its successors are first deducted from the ordinary income portion of the gain; any selling expenses that remain are then used to reduce the taxpayer’s capital gain.
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If the taxpayer waits five years after selling lots (or parcels) from a tract of real estate, the gain on the sale of up to five additional lots from the same tract will be taxed as a capital gain.
Example 1: In May 2008, Smith subdivides a tract of land he purchased in September 1997 into 10 lots and sells five lots for $90,000 each. If the adjusted basis for each lot sold is $60,000, then Smith has a long-term capital gain of $30,000 per lot ($90,000 selling price - $60,000 basis).
Example 2: In June 2009, Smith sells at a price of $100,000 per lot the remaining five lots in the tract of land he purchased in September 1997. In this transaction, Smith will realize a $40,000 gain on each lot sold ($100,000 selling price - $60,000 basis). But since Smith has sold more than five lots from this tract of real estate in a five-year period, he must treat a portion of the total gain for each lot as ordinary income and the remainder as long-term capital gain. Thus, 5% of the selling price of each lot is subtracted from the total gain of $40,000 to yield $5,000 in ordinary income ($100,000 x 5%) and $35,000 in long-term capital gain per lot.
Additional relevant articles on real estate capital gains are listed below:
Many happy returns, Roger
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