Thanks to $250k tax exemption, selling local property and moving out of state as viable an option as ever.

Today, I decided I would write about the skyrocketing home prices and the income tax implications of a sale of a primary residence. Before I wrote a single word, I wanted to see if and when I had written about real estate in my column in the past.
I did a search on “real estate” in my column folder. Interesting, in about every other column I mention something about real estate. This is not surprising since real estate is such an important asset nearly everyone’s net worth.

Two years ago I wrote a column dealing with taxation of real estate sales. My opening paragraph said, “ Housing values in the Napa & Sonoma Valleys continueto skyrocket. The average price is now over $400,000. Who could have imagined these prices just a few years ago?”

Just two years ago, we were appalled by prices averaging $400,000. Already they are the “good old days.” Average prices have now blown through $500,000. Where can you find a house for $400,000?
Virtually, nowhere close to here.
I went on in that 2003 piece to say,” Some homeowners are deciding to cash in on their profits and head for residential areas that are more reasonable. I have had clients move to Nevada, Oregon, Utah, Idaho, ,Florida and even Arkansas. Real estate dollars go much farther in these places.” This is now truer than ever except people are adding another hundred grand or two to the get-a-way booty.

I went on in that piece to discuss the income tax ramifications of the sale. Here is an updated version of the remainder of that column.

With all the growth, one question every seller must consider is whether there is a capital gain tax due on the sale of their home? Capital gains on residential property sales can be a little tricky, but for most sellers, it is relatively simple.

If you are a single homeowner, you get an exemption of $250,000 on any gain over your cost basis. Cost basis is usually the original purchase price plus any permanent improvement plus certain settlement fees or closing costs. You can also add any costs you’ve had to fix up the house for the sale. If you are married,and file a joint return, the exemption is $500,000.

Let’s use an example. Let’s say you are single and paid $100,000 for your home at purchase and you added another $50,000 over the years for improvements. If your sale is for $550,000, you have a gain. $100,000 plus $50,000 plus the exemption of $250,000 adds up to $400,000 and therefore you have a gain of $150,000. A long-term capital gain tax is due plus don’t forget the state income taxes too.
In this example, if you were married filing jointly, you would be “gain free” since the exemption is $500,000 and you are below that level.
There are a few requirements to qualify for the exemption. First you must have lived in your home as your primary residence for two of the last five years. Next, you cannot have sold another residence within the last two years. Also, you cannot have used you home as home office where you took of the value as a business expense.
There are a few other complexities, if you bought your home before May 7, 1997 and you rolled a gain from a prior home to your new home. This could dramatically affect your cost basis.
You may want to order Publication 523 “Selling Your Home” from the IRS to review these rules and be sure you use a competent tax advisor before assuming you have a major windfall.
Remember that your home doesn’t have to be a single-family house. It can be a condo, a mobile home, or even a houseboat if that’s where you live.
Also, if you purchase another home with the proceeds from this sale, you get the same exemptions again as long as you meet the residential requirements usually just living in the house as your primary residence in two of the last five years. Some homeowners, with multiple properties will use this strategy to avoid the gains on several homes or rentals.

For most of our country, these exemptions minimize the income tax bill on the sale of primary residences.
The good news about California is that we have been fortunate to enjoy massive appreciation beyond the exemptions and may have to pay some taxes, but the increases have been phenomenal.
If you have owned your home for less than two years and are compelled to move for changes in employment, health or due to “unforeseen circumstances,” you may be able to prorate the gain.

Congress failed to define “unforeseen circumstances.”
These exemptions have not been indexed for inflation. Since the national average home price in April of 2005 was $206,000, don’t hold your breath for any increases. Most of the country cannot imagine our real estate prices.
One last thought, if you hold your property until you die, you heirs usually receive a full cost basis step-up to the appraised value at the time of death. This may allow the heirs to avoid the capital gain completely after you are gone.

Be careful about adding your heirs’ names to your title just to avoid probate. It could be costly for several reasons including the loss of some of the exemptions.
Notable Quote: No money is better spent than what is laid out for domestic satisfaction. -Samuel Johnson

(Tom Mills & Jonathan Gates are partners in Mills, Parker & Gates LLC, a registered investment advisor.
If you have questions or topics, you may call or write Tom or Jon at 809 Broadway Sonoma CA 95476 (707) 996-7800, FAX (707) 938-8668 or e-mail suntrm@aol.com)