It’s Friday, so it’s time for this week’s reader-submitted Q & A. If you’d like to submit a question, click here for more information or simply email a question.

I purchased a home in Nov. of 2008 for $200,000. In July of 2009 I sold it for $265,000. If I am using all of the proceeds from the sale to pay for my new house, will I still have to pay capital gains tax on the profits because I did not live in the house for two years? What rate would the tax on the profits be?

-Rene M., Ventura, CA

Straightforward Answer:  You probably won’t have to pay any capital gains taxes, but not for the reason you think.

More Detailed Explanation

Back in 1997, Congress changed the rules governing the taxation of a gain realized on the sale of a personal residence. Until that time, you could defer your gain (and not pay any capital gains taxes) on your residence as long as you used the proceeds of the home you sold to buy a home that was, roughly speaking, at least as expensive as the home you sold.  I think that may be why Rene mentioned “using all of the proceeds from the sale to pay for my new house.”

Today, that fact is meaningless.  Since 1997, new laws have governed what you can exclude (not just simply defer) from tax as a result of selling your personal residence at a gain.  (Admittedly, there have been a lot less questions about this since the housing crisis began, but it appears something went well for Rene.)  Now, you can exclude up to $250,000 of gain ($500,000 if you’re married) permanently.  The most important criteria to qualify are that you must own and live in the home for at least two of the five previous years before the sale date.  That’s where Rene ran into a problem,  since she only owned the property for about eight months.

If Rene sold her home due to a job change, declining health, or other unforeseen circumstances (as outlined by the IRS), then she may qualify for a reduced exclusion. If she just didn’t like her home anymore and wanted to go across the street, she won’t.  She’d owe tax on her gain of approximately $65,000. Her rate would be the short-term capital gains rate, which is the same as her ordinary tax rate (based on her income).  The preferable lower capital gains tax rates are only applicable for assets held more than one year.

Assuming Renee qualifies for one of the stated reasons, however, her reduced maximum exclusion would be eight divided by 24 (eight months representing the time she actually did own the home,  24  being the number of months she would have had to own the home to get the maximum exclusion). Assuming Rene is unmarried, 8/24 is then multiplied by $250,000. The result is $83,333, which exceeds the $65,000 gross profit on the home.  As such, it’s unlikely she’ll owe capital gains taxes.

Please note that there are some intricacies to the tax law on which I have not gone into great detail (see aforementioned housing crisis for reasons why I’ve decided to spend my time educating you elsewhere at the moment).  For example, less than the full $65,000 might have been taxable had Rene, for example, added a bedroom during the eight months she owned the home. Such details are why, when you have a big event in your life, it’s worth considering hiring a professional tax-preparer.

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