The way taxes are calculated on the sale of a personal residence hasn’t changed in decades. The ability to exclude capital gains of up to $250,000 for singles and $500,000 for married couples is so established that many tax professionals don’t even know it was ever taxed a different way. Maybe it’s time to revisit the way we treat capital gains on personal residents?
I’ll be honest, I am tired of thinking and talking about the Paycheck Protection Program because it keeps changing and, as soon as you think you have it figured out, the Treasury, IRS, or SBA issues new guidance that makes you start over. It’s exhausting. I think this is why the AICPA is sitting back and waiting until the next piece of tax legislation is passed before they spend more time in the details of the PPP. So this TaxTipTuesday is more educational and intended to give you another tax topic to think about and distract you from your frustrations with the PPP, ERC, EIDL, CARES Act, etc.
I really hadn’t thought about this topic until I was talking to my neighbor over this Memorial Day Weekend. It came up because the house across the street from us is up for sale, and the price is quite unbelievable. We live in a condo and our condo prices haven’t gone up as fast as the houses across the street which aren’t in our condo community. He was asking about the gain on selling a house like that and I explained the general rule. I’ve been in my house 20 years and he’s lived next door to me for 17 years, so we’re both starting to think about our exit strategy and maximizing the amount of gain we can exclude without having to leave our neighborhood.
The general rule on the sale of a personal residence is that there is no tax on the capital gain from the sale of a personal residence for gains up to $500,000 for married couples filing jointly and $250,000 for single individuals. This exemption from tax only applies to residences that the taxpayers have occupied for at least two of the last five years and you can only claim this exemption once every two years. There are other exceptions to these rules and you can read about them in IRS Publication 523.
As I was telling him this, my mind was working up a back of the envelope amount of gain I assume our across the street neighbor will have on this property. In just a few years of ownership, I am expecting the gain on this sale to be more than the amount available to exclude.
Then I started thinking to myself that I don’t think that gains on these sales were expected to be taxed so soon. That is, I think when the initial exclusion amounts were set in stone, it would have taken a lot longer to completely use up that $500,000 of gain exclusion, even in rapidly gentrifying neighborhoods like ours.
Taxpayer Relief Act of 1997
The Taxpayer Relief Act of 1997 ushered in the way we currently treat the sale of personal residences. This law was signed by President Clinton on August 5, 1997. I had just graduated from college, passed the CPA exam, and was preparing to move to Dallas, TX, to start working for Coopers & Lybrand, LLP. I only mention this because it means that the tax section of the CPA exam back then included the old law, so I’m familiar with it but really rarely used it once I started working.
If we want to look at how the gains on sales of residences have changed, lets first look at the average home price back then compared to now. According to the US Census website, the median home price in August, 1997 was $144,000 and the average home price was $170,700. Compare those amounts to the current prices based on the first quarter of 2020, where the median price is $327,100 and the average price is $384,800.
| Price for houses sold in the US | Median Sales Price | Average Sales Price |
|---|---|---|
| August, 1997 | $144,00 | $170,700 |
| Q1 2020 | $327,100 | $384,800 |
The amount of the gain that’s eligible to be excluded from taxable income hasn’t changed since 1997. As you can see, in 1997, the exclusion about for married filing joint and individuals was much greater than the average sales prices. However, by 2020, the average sales price is greater than the exclusion amount for single tax payers while it’s still less than the exclusion amount for married couples filing jointly.
This bring up an issue I’ve always struggled with. When tax law includes specific dollar amounts that aren’t indexed for inflation and are allowed to rot on the vine for decades, they inevitably lose their their targeted audience. Back in 1997 the excluded amounts would have been applicable to a much higher income bracket of taxpayer than what we’re seeing currently.
In my mind, the intent was that most people would be able to exclude the gain from the sale of their personal residence back in 1997. In order to make that applicable to today’s home values, the amounts should be indexed to inflation, and I would guess possibly doubled and then indexed for inflation going forward.
Before the Taxpayer Relief Act of 1997
So, what did we have before the Taxpayer Relief Act of 1997? Well, I’m glad you asked. Prior to this Act, homeowners had to pay capital gains taxes when they sold their homes unless they used one of two different exclusions:
The “Roll-Over Rule”
Using the roll-over rule, a homeowner could postpone tax on the gain from the sale of their residence by purchasing another home of equal or greater value within two years. This was similar to a like kind exchange.
The “Age-55 Rule”
Using the age-55 rule, a homeowner age 55 or older could claim a one time exclusion of up to $125,000 from the gain on the sale of their residence.
Back then, the use of these two rules kept most people from paying taxes on the sales of their residences. However, home prices were rising and I’m sure that’s why they decided something needed to be fixed because more people were starting to get hit with capital gains taxes on the sale of their residences.
As a side note, the rollover rule had been in the tax code since 1951 and the Age-55 rule had been in the code since 1964. Here’s a neat chronology of the evolution of the Age-55 Rule.
1964 – taxpayers who were 65 and had lived in their house 5 out of the past 8 years could use a once-in-a-lifetime exclusion of $20,000 against taxable gains.
1976 – the maximum exclusion amount was (generously) raised to a whopping $35,000.
1978 – the age limit to use this exclusion was lowered to 55 years old, the time limit was changed to be living in the residence for 3 out of the previous 5 years, and the maximum exclusion amount was raised to $100,000.
1981 – the maximum exclusion amount was raised to $125,000. This wasn’t changed until the enactment of the Taxpayer Relief Act of 1997.
Going forward?
I don’t know what the right answer is for whether we should revisit the way we tax the sales of personal residences. I do think that based on the history of how they have been taxed over the years, it is time to look at it with a fresh set of eyes and take into account the inflation that has happened.
There are a lot of tax policy issues that come into play when it comes to taxing the sale of personal residences. Maybe we’re fine with saying $500,000 or $250,000 is enough to exclude from taxes but it is starting to hurt ordinary people who don’t move around frequently. Maybe it’s time to add this to the list of items for the next round of tax reform.
Further reading:
As I was looking up some information on this topic, I found a few websites that can give you more background on the topic.
The Effect of Capital Gains Taxation on Home Sales: Evidence from the Taxpayer Relief Act of 1997