When congress revised the tax laws in 1997 and offered a $250,000 per owner tax exemption for profits realized on the sale of a principal residence, they clearly didn’t live in this area. What was intended as a bonus for home sellers in most parts of the country actually discourages some owners in this area from selling their homes, and that may be part of the reason for our chronic inventory shortage in this area. Here is an example.

 

Let’s say a hypothetical couple, the Browns, purchased their principal residence, a 2 story colonial, for $300,000 in the early 1990’s. That same home may be worth $1,500,000 (probably more) by now. If the couple wants to move from a 2 story home to a single story home of the same value, they may be in trouble. Even after they deduct the original cost of the home plus the purchase and selling expenses from their selling price, their profit would be at least 1,100,000. Each person (assuming they had lived in the home for at least 2 of the last 5 years) is entitled to a $250,000 tax exemption. So, they would deduct a total of $500,000 from their profit and owe tax on $600,000. At the long term capital gain tax rate of 15%, they would owe $90,000 in taxes. Their purchasing power has been substantially decreased. If their replacement home costs the same as the one they are selling, they would have to take out a larger mortgage, or did into their savings, to be able to complete the transaction.

 

There is another potential tax complication that sometimes makes their turnover even more difficult. Most of the time, their property taxes will be based on the purchase price of their new home. At a base rate of 1%, they will now owe $1,250 per month in property taxes as opposed to approximately $375, allowing for inflation, on their older home with the same market value. As a result, many empty nesters feel trapped in their older homes. They don’t want their property taxes to nearly triple each month, and they don’t want to carry a larger mortgage than what they had in their older home.

 

One thing they should keep in mind is a once in a lifetime allowance for sellers over 55 years of age to transfer the tax base of the house they are selling to the one they are buying if they purchase a home of less value (even $1 less!!) than the one they are selling. This applies if they buy their replacement home before closing on the one they are selling. If they close on the one they are selling first, they are entitled to this exemption as long as the cost of the replacement home does not exceed 105% of the one they sold if they purchase within one year, or 110% if they purchased within the second year after selling. After the second year their ability to carry over their tax base disappears completely. And it is only available in certain counties. Fortunately Santa Clara County is one of these! And a very few counties also allow qualifying buyers from another county to bring their old tax base with them. This can make a huge difference in the decision to downsize for qualifying couples or individuals. 

 

The $250,000 per person tax exemption on the profits from the sale of a principal residence is not always a bad thing. I have several clients who have moved into a rental property they owned, lived there 2 years to qualify for the exemption, and then sold the property. They can do this every 2 years, so if they own another rental property after selling the first, they can then move into that, live there for another 2 years, and then sell it. I know one couple who has done this 4 times already, each time pocketing $500,000 free and clear of taxes. It makes for a great retirement fund!!

 

And here is one more tactic used by savvy investors to purchase their dream retirement home. If they have a rental property they have owned for a long time, they would probably owe a substantial tax if they sold it outright. However, they can defer the taxes by exchanging it for the home they want to retire to, rent that out for at least a year or two (to establish it as a legitimate investment property) and then move into it themselves, thereby converting it into their principal residence.

 

If you are interested in utilizing any of these strategies to save on taxes and profit from property you presently own, please do contact me. This is not meant to be a comprehensive explanation of the current tax laws, which are quite complicated, and consultation with a tax professional is always advised.

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