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No tax on gain from sale of primary residence? Think again!

It's Your Money

Posted: April 10, 2008 8:09 p.m.
Updated: June 11, 2008 5:04 a.m.
One of the most depressing moments I had during this tax season (of which I had several) was having to tell a retired lady that she owed close to $40,000 in taxes when she thought she was going to get a refund. The culprit that caused this unfortunate surprise involved the sale of her primary residence. Here is her sad story.

This very nice lady came in for her tax appointment a few weeks ago and announced that she had sold her house in the San Fernando Valley and rolled the gain over into a new house she bought here in the Santa Clarita Valley. I told her that we can no longer roll over gains from one primary residence to another. In place of that lapsed tax provision is one where we have been given a generous gain exclusion. I still felt confident that she would be OK, but to be sure I asked her how long she had owned the previous residence.

She replied that it was bought in the early 1960s.

I then asked her, "For how much?"

She said "About $28,500."

My next question was "How much did you sell if for?"

She said, "$500,000."

Knowing that she is single, I had to tell her that the gain exclusion for her was $250,000 (for married filing joint the gain exclusion is $500,000). Taking into consideration the closing costs, and then quizzing her as to home improvement costs over the years, I had to tell her she would be having to owe some $39,000 in taxes. This literally crushed her. She had put a good deal of the sale proceeds into the new house thinking that she needed the new house to protect her from taxes (outdated law). So her cash resources to pay the tax was limited also. Needless to say, I felt terrible having to be the bearer of such bad tidings.

Another thought and concern that we tend to overlook: Remember the old law? You could defer gain on the sale primary residences by buying one of equal or greater value? What this had done was to keep your actual cost basis much lower than what you actually purchased the last property for.

Example: Say over the years you have bought and sold homes and deferred accumulative gain on the sale of those houses of about $150,000. Your current residence was purchased for $300,000. You are thinking of selling and the current value is $750,000. You are married, so you have a $500,000 exclusion. You have no gain to be taxed right? Seven hundred fifty thousand dollars less $300,000 is $450,000 gain, which is less than $500,000 so you are fine, yes? WRONG! Your actual cost basis is really $150,000 ($300,000 less $150,000 of deferred gain from previous sales). Taxable gain of $100,000 would have be recognized and taxes paid, both at the federal and state levels.

What can be done? For one, keep good records of any home improvements made such as the addition of a room, remodeling, landscaping, etc.

These costs increase the cost basis of your home and will reduce potential capital gain.

Second, you might sell your home while the gain is still within the exclusion limits to avoid having to pay tax later. It may be a costly move given the cost of selling but nevertheless, something to consider.

Third, just wait a while longer. With our residential homes dropping in value, if we wait long enough the tax problem may just go away. A little morbid humor there.

Fourth, remember that the old law of rolling over gains on primary residences does not exist any more. Be aware of the tax implications going into the sale instead of being shocked at the time you have your tax returns prepared.

A word to the wise from Frank Norton.

D. Frank Norton CPA, MBA, CFP, is a money manager and financial planner in Santa Clarita. His column represents his own views, and not necessarily those of The Signal. "It's Your Money" appears Thursdays and rotates between a handful of the valley's financial professionals.


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