Changes to Capital Gain Tax Treatment of a Primary Residence

Just when we think we have the income tax laws regarding real estate figured out, the federal government has to go and change them again! This time the changes come as part of the 2008 Housing and Economic Recovery Act (HERA), H.R. 3221, an attempt on the part of government to help individuals impacted by the current mortgage crisis without spending money to do it. It's called "revenue neutral", which means that they have to collect more money from somewhere to pay for it.

The additional collection relative to real estate comes from a change in the way profits (capital gains) from the sale of a primary residence are (or are not) taxed. Currently, if a person sells a house for a profit (capital gain) after living in it as their primary residence for 2 of the past 5 years, there is no capital gain tax due on $250,000 of the gain for a single person or $500,000 for a couple. They are free to do whatever they want with the money and there are no age restrictions.

Americans are a creative people, particularly when it comes to avoiding taxes, and during the recent boom, this tax provision provided an incredibly easy way to make money. Let's look at a simplified example:

A couple owns a house (their primary residence), a vacation home and a rental house. They sell their primary residence, take $500,000 in tax-free profit and move into their rental house. They live there 2 years, sell it, take $500,000 in tax-free profit, buy a home where they want to retire and move into their vacation home. They live there 2 years, sell the former vacation home, take the tax-free profit and move into their retirement home. 3 sales, no capital gain tax.
The sale of a former rental does have some tax implications regarding recapture of depreciation, but that has been minimal relative to the potential for gain.

Congress has decided that this scenario does not fit the original intent of the law, which was to eliminate capital gain taxes on the increase in value of a person's home. As of January 1, 2009, there will still be no capital gain tax due on a profit generated by the sale of one's personal home where they have lived for 2 of the past 5 years, with the following exception:
If that home was converted to a personal home from a rental or vacation property, capital gain tax will be due on that percentage of the gain equivalent to the percentage of time that the house was used other than as a primary residence since January 1, 2009.

For most homeowners, this change will be of no concern, but many knowledgeable people have incorporated this tax provision into their financial planning. It has always been important to talk with your financial advisor or accountant before making a decision to sell property, and never more so than now.

Capital Gains Tax & Your Primary Residence

Capital gains tax is a tax levied on the profit made on the sales of any property sold. The tax is levied on the difference between the amount the asset was sold minus the original cost of the property and the cost of any improvement made on it. It was introduced to South Africa in October 2001.

Who Pays it?

Everybody resident of the country must pay the tax on all property sold irrespective of the property's location i.e. both properties inside and outside South Africa are taxable. Furthermore, non South African residents that have private assets or businesses in the country are liable to be taxed.

The Details

Each year while you are filing the year's income tax return, the capital gains on all the properties sold including your primary residence will be filed as part of the taxable income. The capital gain is calculated by subtracting the base cost of the property in question from the property's sale price. It should be noted that the property's base cost is not just the original price that you paid to get it. It also includes all other costs that you may have incurred on it such as improvement costs, stamp duty, charges paid to your attorney or estate agent etc.

The South African Capital Gains Tax, CGT, has a few additional rules that apply to the administration of the tax. For example, the first 10,000 rand of your capital gain is excluded from your taxable amount if you are considered as an individual for tax purposes by the South African Revenue Service. Your capital gain less the capital loss gives you your total gain. So, any gain made after the first 10,000 is then taxed at 25% for a primary residence only. On the other hand, a tax of 50% of the total gain will be exerted on a property that is not a primary residence These regulations are applied yearly to the income tax return.

Properties Exempted from the Capital Gains Tax

Under the administration of the tax in South Africa, almost all assets are considered taxable. However, a few of them are exempted. An example is a property that is being occupied by the owner. Other conditions need to be met though. For example, the property's worth should not be more than R1, 000,000 and it should not have more than 2 hectares of adjacent land to the residence. Other assets exempted are personal belongings, earnings from gambling, private automobiles, retirement benefits and annuities etc.

How to Calculate Your Assets

The base cost of your property can be computed using two methods. These are the valuation and time apportionment methods. For the valuation method, the property's value as at October 2001 must be known. For the second method, the capital gain on the property is calculated back in time from the time it was initially purchased to the time it was sold. After this, the gain that occurs after October 2001 is then factored out. This second method is a little bit more complicated to understand and compute.

The Primary Residence Exclusion

One of the greatest tax gifts is the principle residence rules for capital gains on the sale of your home. So great is the principle residence tax exclusion that even married couples filing jointly are benefited to the same, if not greater, extent as single taxpayers. Now, some people may argue that there have been, are and will be greater gifts, but not much beats the simplicity of this rule. The basics of it are immensely easy to grasp: you own a house, you live in it for at least two years, you sell it and you don't pay any taxes on the gain. Gone are the days when the young homeowner (not wishing to sell and upgrade) had to save every receipt for every upgrade, every repair, every minor item bought at the hardware store. If you have lived in your own home for two years, you probably don't have to worry.

Of course, there are some technicalities associated with the general rule. They are pretty simple so first I will bullet-point the main ones:

o If you are single your capital gains exclusion is limited to $250,000.00

o If you are married your capital gains exclusion is limited to $500,000.00

o You have to own the home and it has to be your "primary residence" for two of the previous five years

What is your "primary residence"? Basically, it is a home that you personally live in the majority of the year. If you have a house in Palm Beach and one in Lake Tahoe and you spend 8 months of the year at the Tahoe home than that is your primary residence. But, keep in mind the 2 out of 5 part of the rule. Let's say that the next year you spend 7 months at the Palm Beach house. Then the Palm Beach home is your primary that year. See where I am going with this? You can primary more than one home at once over a five year period so long as each is your main home for at least two years during that five year period. Temporary absences are also counted as periods of use - even if you rent the property during those absences (but talk to your accountant about recapturing any rental depreciation).

Now don't let the five year requirement confuse you - it only takes two years to achieve the tax exclusion. The five year part is a bonus, allowing you some freedom. You don't have to personally use the home as your primary residence for two consecutive years or for the two years immediately before you sell, you just have to use it is your primary residence for two of the previous five years. But, it is also a limitation, you cannot live in a house for two years and then rent it for four years and then get the exclusion. You could live in it for two years and then rent it for three years and then sell it (so long as it is sold within the five year mark from when you first lived in it as your primary residence).

Also, bear in mind that married couples do not have to live together. So long as one spouse lives in the primary residence for the two years than the couple can take advantage of the $500,000.00 exclusion. But, they cannot primary two homes at once and get the $500,000.00 exclusion on both. If they live apart during the two year period and each sell their primary then they are each limited to the single taxpayer exclusion of $250,000.00 for each house.

If you have a home office or rental as part of your primary residence or run a business out of a portion of your property, your ability to maximize your capital gains exclusion largely depends upon whether the home office, business or rental was part of your home (in the same dwelling unit) or a separate part of your property (a separate building or apartment). If the business use of your home was contained within your dwelling unit then upon sale you will need to recapture any depreciation taken for that part of the home. But you will not lose any of the allowable capital gains exclusion ($250,000.00 for single taxpayers and $500,000.00 for married filing jointly). If the business use of your home was not a part of your dwelling unit then you need to bifurcate the sale by allocating the basis of the property and the amount realized upon its sale between the business or rental part and the part used as a home.

Remember, only one home can be sold in any two year period unless you and your spouse live apart, and even then you can each only take the single payer exclusion of up to $250,000.00. But what if you need to sell a home that you have not lived in for the full two years? The IRS tells us that in special circumstances you can sell a home before you reach the two year mark and get a pro-rated exclusion. An example of a pro-rated exclusion is, for example, if you are a single taxpayer and have to sell your primary residence for a qualified reason after living in it only one year than you could exclude up to $125,000.00. In other words, you lived in the home 50% of the requisite time so you can take 50% of the allowable exclusion. The special circumstances that qualify you for this safe harbor and allow you to take the pro-rated exclusion have to do with health (yours and certain qualified individuals such as close relatives), change of employment or what the IRS calls "unforeseen circumstances" (examples include death, natural or man-made disasters, multiple births form the same pregnancy, divorce) These circumstances also have to cause you to sell your home. Factors used by the IRS to determine causation include:

o Your sale and the circumstances causing it were close in time,

o The circumstances causing your sale occurred during the time you owned and used the property as your main home,

o The circumstances causing your sale were not reasonably foreseeable when you began using the property as your main home,

o Your financial ability to maintain your home materially changed, and

o The suitability of your property as a home materially changed.

1031 Exchanges and the Primary Residence Rule

What happens if you do a like kind tax deferred exchange (also known as a 1031 exchange) of rental property or other property held for investment and then later decide to live in the property that was purchased? It is crucial to your 1031 exchange that both the property sold and the property purchased are held for investment. The property purchased must undergo a holding period before it is resold or converted into non-investment property. That holding period should be a year and a day to avoid audit. After you have complied with the "held for investment" requirement by, for example, renting the property if it is rental property, then what? Well, you could sell the property and pay your taxes on that sale and all previous sales that were perhaps in a series of exchanges or exchange and defer the tax once again, OR you could live in the house as your primary residence. If you have a had a series of gains that you have deferred this is a way to extinguish your tax debt forever - all you have to do is move into your investment property once the holding period for it qualifying as an investment is over.

Gaining the primary residence exclusion for property that was 1031 property isn't as easy as the simpler primary residence rules talked about above, but it does allow you to take advantage of two loopholes at once! The main difference when primary residencing a 1031 exchanged property is that you actually have to hold the property for 5 years. The five year part here is a substantive rule, you cannot sell after only 2 years of ownership as you can if you were simply primary residencing a home that was not exchanged into. But that first year that you had to hold onto the home for investment goes towards the five year calculation. So, you rent it for two years and live in it for three, or vice-versa, so long as you kick the whole thing off with a one year rental period and live in it two of the remaining four years.

In this way, you can exclude up to a total of $500,000.00 worth of gain (if you are married filing jointly or $250,000.00 worth of gain if you are a single taxpayer) from the combined gains of the sale of the home you ended up living in as your primary residence, and any of the gains that you had previously 1031 exchanged. For example, say you purchased a duplex in May of 2000 for $150,000.00 and then in June of 2001 you 1031 exchanged the duplex (now worth $200,000.00) into a commercial building worth $200,000.00 (thus deferring $50,000.00 worth of gain). A few years later the commercial building is worth $300,000.00 and you do another exchange, this time into a nice single family home worth $350,000.00 (you have to put in an additional $50,000.00 to complete the purchase). You have now deferred a total of $150,000.00 worth of gain. Let's say you then choose to rent the home for the first two years that you own it and then you later decide to move into the home. You then live in the house for three years at which point it is now worth $700,000.00 and you sell it for this amount. You and your spouse have now effectively wiped out not only the $350,000.00 gain from the sale of your primary residence, but the previous $150,000.00 worth of gain as well.