From a reader:

Subject: Q Sale of principal residence in 2013 which was rental property from 1986 t0 2002 – Do we have to recapture depreciation and pay capital gain on depreciation

Hello Mr. Kerstetter:

We have recently moved to a new area after the sale of our principal residence. Not knowing a lot of people in this area, I have tried to find someone who knows for sure if we will owe capital gains on the sale of our single family home, which we occupied from 2003 thru 2013. The home was a single family rental from 1986 to 2002, on which we took S/L depreciation.

I have asked potential tax preparers if they know the answer, and they have given a variety of answers, from “you will owe nothing as you sold for under $250,000 and you lived in it for 2 out of 5 recent years”, etc. Others indicate they will have to research the answer. As you are the tax guru, we would appreciate your view since we want to file tax return correctly by April 15th.

Thank you for your anticipated reply.

My reply:

Actually, the law is fairly explicit on this issue.

Any depreciation you claimed after May 6, 1997 will have to be recaptured and reported as income on your tax return.
The rest of the gain will be tax free.

Good luck.  I hope this info helps.

Follow-Up 1:

Mr. Kerstetter:

Thank you for your quick reply. From what I had read, I thought this might be the answer, but could not get a definitive answer from potential tax preparers, who I now hesitate to hire. Do you think I could accomplish an accurate return using Turbo Tax on my own? (I have used Turbo Tax in “uncomplicated years” previously.)

I called the I.R.S. for clarification last week and was on hold for 1 1/2 hrs — no one ever picked up the line.

My Reply:

I have never been a fan of DIY tax programs, except for the most basic 1040-EZ type of tax returns.  If any other schedules or forms are needed, such programs are actually dangerous.  It’s similar to giving you a scalpel and a copy of a medical book and assuming you can perform surgery on yourself or on a loved one.

DIY tax programs are the best illustration in the world of the old adage for computers, GIGO (Garbage In, Garbage Out).  Even the most expensive tax programs, such as the one I use (Lacerte), can’t do the job on their own.  They require knowledgeable users who know how to enter data properly to prepare a correct tax return with the lowest legal tax.

Any experienced preparer should be able to help you reduce your taxes by more than what his/her fee is, in addition to reporting the recapture gain properly.

In regard to locating a good tax preparer, you should check out the tips I have on my website.   You can also quiz potential preparers with the recapture rule we have been discussing.  It’s been the law since May 6, 1997; so anybody in the tax business should know it and have actual real world experience working with it.  If not, you should find someone else.

Good luck.

Kerry

Follow-up #2:

Hello Mr. Kerstetter:

Thank you for your reply to my question. You would be surprised at the answers I have rec’d from potential preparers. After explaining my situation, I have asked “have you had to deal with this type of situation before?” and none of the respondents have said “Yes”.

I will visit your website as suggested, and will look for a preparer in this area I feel is competent.

Thank you again.

My final comment:

Actually, I am very surprised that so many preparers haven’t had to work with a provision of the tax code that has been in place almost 17 years now.

Maybe it’s because real estate taxation has been a kind of specialty for me; but I have seen it in tons of client cases; not just for converted rentals, but also for home office situations.

Good luck in locating a new experienced professional preparer.

Kerry

Q:

Hi,

 Reading up on Sale of Principal Residence tax matters.  Do you folks have any insight as to if the $250/$500K exclusion is likely to continue on through 2013?  

I have a couple of houses and am seriously thinking of selling the principal residence due to the favorable tax treatment.

Thanks

A:

Even with all of the discussion of different kinds of tax increases, I have seen no mention of eliminating the tax free residence provision, so I would bet that it will be with us for all of 2013.

The more difficult task for you will be to find someone who wants to buy your residence in spite of the looming bankruptcy of the State.

Good luck.

Kerry Kerstetter

Q:

Hello Tax Guru,

Three years ago I re-married, after having been a widow for 7 years. Title of the house was at my husbands death transferred to my name only.

My new husband also owns a home, and I wishes to sell mine, what steps are necessary to obtain a full marital tax deduction of $250,000.00 x two. Add my new husbands name to the deed of course is the obvious, but will we then have to wait to sell the house in order to qualify?

Yes, we have lived in the house for two of the past 5 years.

Thank you very much for your assistance.

A:

It appears that you already qualify for up to $500,000 of tax free gain from the sale of your residence, per this section from IRS Pub 523, which you can see at:
http://www.irs.gov/publications/p523/ar02.html#en_US_2010_publink1000200739

Special rules for joint returns.   You can exclude up to $500,000 of the gain on the sale of your main home if all of the following are true.

You are married and file a joint return for the year.

Either you or your spouse meets the ownership test.

Both you and your spouse meet the use test.

During the 2-year period ending on the date of the sale, neither you nor your spouse excluded gain from the sale of another home.

If either spouse does not satisfy all these requirements, the maximum exclusion that can be claimed by the couple is the total of the maximum exclusions that each spouse would qualify for if not married and the amounts were figured separately. For this purpose, each spouse is treated as owning the property during the period that either spouse owned the property.

Good luck.  I hope this helps.

Kerry Kerstetter

Follow-Up:

Hello Mr. Kerstetter, 

We appreciate your reply and good information. 

Thank you very much.

Q:

Subject:  Sale of Primary Residence

I am trying to find out when the $500,000 ($250,000 per spouse) Exclusion expires; and what is the current thinking on how it would be changed.

Sincerely

A:

The current law allowing the tax free exclusion of some or all of the gain from the sale of a primary residence (aka Section 121) was enacted in May 1997 and does not have an expiration date.  It will be the law, with the exact same dollar amounts (unadjusted for inflation) until our rulers in DC explicitly change it.

While nobody can know for sure what changes, if any, this law will have in the future, I can guess at a few possible ones.  It is very likely that some provisions of this law will be trimmed back for home sellers.

Going back to a once in a lifetime usage, rather than the current once every two years, would probably be a politically acceptable change since that was how it applied for several decades prior to 1997.

Another likely change with the growing sentiment in DC to screw over the evil rich would be to completely or partially deny the exemption to those taxpayers with AGIs over a certain dollar figure that our rulers will establish to define them as evil rich who are unworthy of any more tax breaks.  Several other tax deductions and credits already have AGI eligibility thresholds; so this would be consistent with that.

Your own personal professional tax advisor should be up on the latest laws in regard to home sales; so any planned sale should be run by him/her first.

I hope this helps.  Good luck.

Kerry Kerstetter

Follow-Up:

Dear Kerry
 
Thank you so very much for the information … it is extremely helpful
 
Sincerely

Q:

Subject:  Vacant Land

If I sale my vacant land and meet all requirements can I still take an Exclusion on the land without the sale of my residence? Still confused about the tax law/ publication #523 any response would be greatly appreciated! Thanks

A:

You didn’t say if the vacant land was connected to your primary residence or not.

I have a section on this topic on my page on home sales.   

Unless you are planing to sell your home within two years of the separate sale of adjoining bare land, it will not qualify for any exclusion of gain.

You really need to be working with a professional tax advisor to see if there will even be any capital gains taxes on the land sale.  There is a special zero percent tax on some gains for some people in 2009 and 2010 that you might be able to utilize.

Good luck.

Kerry Kerstetter

Follow-Up:

KERRY, Yes the vacant land is connected to my primary residence. Thank you for the current reply.

Q:

Subject: Home Sale Gain Exclusion

Situation:
5 years ago, was laid off in Minnesota and had to settle for a California job.
Commuted every 2 weeks for 1 year then moved family to a rental.
Wife and children lived in MN home every time children not in school (about 3 months per year), nevertheless total days is well shy of 730.

Kept a car registered in MN, voted in MN, kept MN drivers licenses, bank account in MN while trying unsuccessfully to transition to a job back in Minnesota.  Even had several in-person interviews in MN over the years.

Finally gave up & sold in Minnesota; just closed.  We expected to exclude 50K of gain.

Can we
A) Exclude the gain because our beloved MN home was our primary residence defined by that we never bought anything else and always considered & treated it as “our home”.
B) Exclude the gain because the wife was always staying there… it may be shy of 730 days but there is no way to audit that.
C) Exclude the gain because I was forced to sell due to a job situation and we used it as a primary residence for 1 year, 50% of the 2 year standard, and all we need to exclude is $25K apiece.
D) SOL

Thanks!

A:

You need to be working with an experienced professional tax advisor to make sure you do things properly here.

It looks like you should be able to qualify for the prorated tax free exclusion based on your change in employment.  Since your gain is only 10% of the total possible Section l21 exclusion of $500,000, there shouldn’t be a problem in excluding the full amount of your profit.
However, your personal professional tax advisor will be better able to evaluate the details of your situation and decide if that is the case.

Good luck.

Kerry Kerstetter

As I was perusing the latest draft tax forms on the IRS website, I came across this file that contains some new worksheets and other info for Publication 523, which deals with the tax free sales of primary residences.

What I was mainly interested in is the brand new provision in the law that limits the tax free exclusion for homes that were also used as a rental or second personal home. For that calculation, IRS has this new worksheet, which is on Page 7 of the draft pdf file.

(Click on image for full size)

Income Gain Exclusions – The Scoop on Code Sec. 121 – From TrustMakers, including the newly passed change.