General Practice, Solo & Small Firm DivisionMagazine
Recent Income Tax Changes Affect Property Owners
BY RICHARD A. SHAPACK
© American Bar Association. All rights reserved. Richard A. Shapack is a principal at Shapack, McCullough & Kanter, P.C., in Bloomfield Hills, Michigan. He is licensed to practice in Michigan and Florida, and has been board-certified as a tax attorney in Florida for 15 years. He is a fellow of the American College of Tax Counsel and is the chair of the ABA Real Property, Probate and Trust Law Section’s Federal Tax Aspects of Real Estate Committee.
Recent changes to the income tax laws affect residential and commercial property owners in two substantial and a number of minor ways. Homeowners have been freed from the tyranny of the one-time exclusion of gain from income. Plus, long-term capital gains rates have been reduced.
On August 5, 1997, President Clinton signed the Taxpayer Relief Act of 1997, the tax provisions of the Balanced Budget Act of 1997, and the Taxpayer Browsing Protection Act (’97 Act). On July 22, 1998, the President signed the Internal Revenue Service Restructuring and Reform Act of 1998 (’98 Act).
For decades prior to the ’97 Act, a taxpayer could avoid recognition of gain on the sale of a principal residence if a new residence at least equal in cost to the sale price of the old residence was purchased and used by the taxpayer as a principal residence within a specified period of time.
Congress decided to change this provision, feeling that it encouraged tax-motivated decisions and created certain potential tax traps for the unwary. Taxpayers moving from a high-cost housing area to a lower one could incur an unexpected capital gains tax liability. Further, the recordkeeping requirements were burdensome and most taxpayers were unable to deal with the distinction between improvements that added to basis and repairs that didn’t.
Prior to the ’97 Act, taxpayers were allowed a one-time opportunity to exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence. To be eligible for this election, the taxpayer had to be at least 55 years of age before the sale and to have owned the property and used it as a principal residence for at least three of the five years prior to the date of sale. If the taxpayer or the taxpayer’s spouse had used any portion of this election in the past, it was not available. This provision required some interesting planning for older taxpayers considering marriage.
The ’97 Act provided that for all sales and exchanges of a principal residence occurring on or after May 7, 1997, an individual taxpayer who has owned and used a property as his principal residence for at least two of the last five years is entitled to exclude from income an amount not to exceed $250,000 recognized from the gain on the sale of this principal residence. For a married couple, this exclusion is increased to $500,000.
How Long Have You Lived There?
Unlike the prior law, a taxpayer can utilize this exclusion as long as she has owned and used her principal residence for more than two years. For example, if an unmarried individual had sold her principal residence in the spring of 1998, having owned and used that residence for more than two years, the gain on that sale, in an amount not to exceed $250,000, would be excluded from gross income.
Further, if she then purchased a new residence, closed on that new residence in May 1998, and used that residence as her principal residence to a date beyond May 2000, the gain on the sale of the residence at that time would again qualify for the exclusion of up to $250,000 of gain. She is entitled to continue to exclude the gain, up to the limits set forth, on an ongoing basis, if she doesn’t object to moving or if her job requires frequent moves.
Another area has been further clarified by the ’98 Act: What happens if the taxpayer fails to meet the requirement that he has used the property as a principal residence for at least two of the five years before the sale or exchange? If this failure was caused by a change of place of employment, health, or unforeseen circumstances, the taxpayer can exclude a fraction of the realized gain.
The ’97 Act contained a transitional rule holding that the reduced exclusion would also apply to a taxpayer who owned and used his residence as a principal residence on the date of enactment (August 5, 1997) and who sold that residence before the end of the two-year period (August 4, 1999), even if the sale was not the result of a change of place of employment, health, or other unforeseen circumstance.
The ’97 Act was not clear regarding whether a taxpayer who had $80,000 of recognized gain and who had sold his principal residence after using it for one year would receive an exclusion of (a) one half of the $80,000 of gain, or (b) one half of the maximum $250,000 exclusion. The good news, as clarified by the ’98 Act, is that (b) is the correct approach. As such, the taxpayer would realize no taxable gain in the above example. It is important to note that without the transitional rule, this exclusion for a period of less than two years only applies to a taxpayer who fails to meet the two-year requirement by reason of a change of place of employment, health, or unforeseen circumstances.
Moving on Up
The ’98 Act added another taxpayer-friendly provision. The ’97 Act provided that as long as either the taxpayer or the taxpayer’s spouse owned the property, for purposes of the ownership test, ownership would be attributed to both spouses. The ’98 Act provides clarification to the situation where a couple marries, moves into his home, and 12 months later must relocate because of her job.
In that situation, assuming that he has both owned and used the residence as his principal residence for more than two years, they would be entitled to the $250,000 exclusion based on his ownership and occupancy plus an additional $125,000 exclusion based on her one year of use of the residence, providing, in the aggregate, an exclusion of up to $375,000. But if the move was necessitated by his job, not hers, then they would receive only his exclusion (i.e., up to $250,000).
There is no requirement to reinvest any portion of the proceeds. The taxpayer may utilize all or any portion of the proceeds in any fashion without any adverse tax implications. So an individual who was not opposed to moving, even within the same community, at intervals of just more than 24 months, would be able to receive tax-free income upon each transaction (to the extent that she is able to continue to buy appreciating property).
Taxpayers who are now in their forties or fifties, and who have legitimately deferred the payment of tax on the gain as they have moved from residence to residence over the past decades by buying increasingly more expensive homes, should consider moving as they near the $500,000 of total gain. The total gain is the aggregate of the gain on all of their previous residences plus the gain that will be realized on the sale of their present residence.
At a 4 percent per annum appreciation rate, a $700,000 home in which the taxpayers had $500,000 of appreciation would grow in value to $1.4 million in approximately 20 years. If the taxpayers sold the first home now, it would result in a tax savings of approximately $100,000 in the future. Remember, though, that nobody knows how the tax laws may change in the next 20 years.
The new provisions offer taxpayers a multitude of planning opportunities. A taxpayer might move to a different residence and rent the prior principal residence. As long as the taxpayer has owned and occupied the former residence for two of the previous five years as of the date of sale (not the date of execution of the sales agreement), the taxpayer will qualify for the exclusion (although a portion of the gain will be subject to long-term capital gains).
Gross income does not include gain from the sale or exchange of property if, during the five-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more. A taxpayer who has significant appreciation in a second home could sell his principal residence utilizing this exclusion and then move into the second home, making it his principal residence. Two years later, the taxpayer could then obtain another exclusion as he sells that residence.
Rental or business use of the taxpayer’s principal residence would result in allowable depreciation deductions. If these deductions were allowable for any period after May 6, 1997, then the exclusion will only apply to that portion of the gain (from the sale of the principal residence) that exceeds the aggregate of the depreciation adjustments allowable. Any depreciation allowable for the period prior to May 7, 1997, will not affect the exclusion.
While this limitation on the principal residence gain exclusion would initially appear to be a cause of concern for those contemplating operating a "home office," this aspect will likely provide an additional benefit. The depreciation taken will be recaptured at a 25 percent maximum long-term capital gains rate while it is likely that the taxpayer was in a higher tax bracket at the time that the depreciation deduction was utilized. As such, a taxpayer utilizing a home office will pay a lower rate at a later date.
With one specific exception, the provisions of the ’97 Act apply for all sales of a principal residence occurring after May 6, 1997. The committee reports provide:
A taxpayer may elect to apply present law (rather than the new exclusion), to a sale or exchange (1) made before the date of enactment of the Act, (2) made after the date of enactment pursuant to a binding contract in effect on the date, or (3) where the replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect on the date of enactment) and the rollover provision would apply.
Particularly for individuals who have utilized the rollover provision available under prior law for many years and have gain in excess of the allowed exclusion under the ’97 Act, this continued deferment might be attractive. However, the ability to make this election is very limited. The ’98 Act broadened this ever so slightly. If the sale took place on August 7th, the date of enactment, the taxpayer would still be entitled to make this election.
The Conference Committee report also contained another interesting provision. "The conferees wish to clarify that the provision limiting the exclusion to only one sale every two years by the taxpayer does not prevent a husband and wife filing a joint return from each excluding up to $250,000 of gain from the sale or exchange of each spouse’s principal residence provided that each spouse would be permitted to exclude up to $250,000 of gain if they filed separate returns."
While such a sale would be rare, the ’97 Act also covers the situation where a taxpayer sells a remainder interest in her principal residence (i.e., she retains the use of that residence for the remainder of her lifetime and sells the remainder interest). Such a sale may qualify for the exclusion if the other requirements are met.
Early Withdrawal from IRAs
The ’97 Act contains a provision, effective for distributions made after 1997, which eliminates the penalty for early withdrawal of IRA funds for "first-time home buyers." This provision adds an exception to the 10 percent early withdrawal penalty for taxpayers making a withdrawal from an IRA prior to reaching age 591/2. The 10 percent penalty will not apply to withdrawals from an IRA (including a Roth IRA) for amounts of up to $10,000 for first-time home buyer expenses. The distribution must be used to pay the qualified acquisition costs of acquiring the principal residence of a first-time home buyer.
The scope of this provision is much broader than one would expect. The first-time home buyer can be the taxpayer, the taxpayer’s spouse, or any child, grandchild, or ancestor of the taxpayer or the taxpayer’s spouse. Furthermore, if the taxpayer (and spouse, if any) did not own a principal residence during the 24-month period prior to the date when a binding contract to acquire a principal residence is executed, even though that taxpayer and/or spouse may have owned a principal residence in the past, for purposes of this provision, such taxpayers are deemed to be first-time home buyers.
Four additional items relating to this provision are important to note: (1) while this provision eliminates the penalty associated with a withdrawal, income taxes will still be imposed on the amount withdrawn; (2) the aggregate withdrawals qualifying for first-time home buyers cannot exceed $10,000 during a taxpayer’s lifetime; (3) the amount withdrawn for this purpose must be used within 120 days of the date of withdrawal (although, if there is a delay or cancellation of the purchase or construction of the residence, the taxpayer may recontribute the amounts withdrawn to the same or another IRA before the end of the 120-day period without penalty); and (4) although the ’97 Act is not clear on this matter, it appears that a husband and wife qualifying under this provision (or the parents or grandparents of such individuals) could each withdraw up to $10,000 from IRAs without the imposition of an early withdrawal penalty.
Because the qualified first-time home buyer is the individual actually acquiring the principal residence, the aggregate of the amounts withdrawn for the purpose of assisting that individual is limited to $10,000. But the 55-year-old parent who withdraws $10,000 for each of his four children for this purpose would not be subject to the early withdrawal penalty. Capital Gains
The ’97 Act made very substantial changes to the capital gains rules, including the extension of the period to qualify for long-term capital gains treatment to a period of "held more than 18 months." However, the ’98 Act returned the definition of long-term capital gain to "property held more than one year," effective for tax years ending after December 31, 1997.
The ’97 Act provided lower capital gains rates for individuals by reducing the maximum rate on adjusted net capital gain from 28 percent to 20 percent and providing a 10 percent rate for the adjusted net capital gain that would otherwise be taxed at a 15 percent rate. The ’97 Act retained the prior law’s 28 percent maximum rate for net long-term capital gain attributable to the sale of collectibles and property held more than one year but not more than 18 months. It also created a new long-term capital gain tax category, which was not changed by the ’98 Act. That category specifically covers the long-term capital gains attributable to depreciation from real estate; such gain is to be taxed at a maximum rate of 25 percent.
Beginning in 2001, the long-term capital gain rates of 20 percent and 10 percent will be reduced to 18 percent and 8 percent respectively for property that qualifies for the 20 percent rate. Also starting in 2001, special provisions allow a taxpayer to elect to have assets governed by the lower rates. This may be accomplished by making certain elections in 2001 and paying the tax at the time of that election on any gain attributable prior to the date of the election. (See a tax law specialist for more information on the particulars of that election.)
Let’s say a taxpayer acquired a non-residential parcel early in 1984 for $1 million and elected to use accelerated depreciation. The property is sold in 1998 when the basis in the property is $200,000 and the balance of the accelerated depreciation (i.e., the excess of the accelerated depreciation over the amount of depreciation that would have been taken had the taxpayer utilized straight line depreciation) is $20,000. The taxpayer nets $1.9 million (after the payment of all closing costs, brokerage fees, etc.). The taxpayer will have a total gain of $1.7 million (i.e., the $1.9 million net sales price less the $200,000 basis).
Of this amount, $20,000 (the net accelerated depreciation) will be taxed at the taxpayer’s ordinary income tax rate; the $780,000 (the § 1250 depreciation recapture amount) will be taxed at a maximum rate of 25 percent; and the balance ($900,000) will be taxed at a maximum rate of 20 percent.
The only possible change to this scenario would be if the taxpayer had a very significant amount of other tax losses so that after recognition of the gain relating to both the recapture of the accelerated depreciation and the recapture of the § 1250 depreciation, the taxpayer was still in the 15 percent bracket. Then, and to the extent that the gain itself would qualify for that 15 percent tax bracket, that portion of the gain would be taxed at a maximum of a 10 percent rate.
Schedule D, the IRS form on which capital gain transactions are reflected, became a monster in terms of complexity to reflect the changes incorporated in the ’97 Act. The 1998 version will be slightly less complex with the return to the "greater than one year" definition of long-term capital gain. But it is still far too complicated.
While a real estate investor might complain that the ’97 and ’98 Acts have not treated real estate as favorably as common stocks, the overall impact on real estate has been quite positive. The residential marketplace has been improved because taxpayers can: (1) make non-tax-motivated decisions regarding their principal residences, (2) make tax-motivated decisions in sophisticated principal residence planning; and (3) in certain instances, utilize funds from IRAs without incurring an early withdrawal penalty.
The commercial and industrial marketplaces have also been improved by the reduction of long-term capital gains rates, even though the portion representing depreciation previously taken will be taxed at a maximum rate of 25 percent. Since real estate continues to receive a valuable tax advantage in terms of the deductibility of depreciation, the recapture of that depreciation at a later date and most likely at a lesser rate is not too onerous. CL