The new law does away with the rollover provision and the $125,000 once-in-a-lifetime exclusion. I don't like to refer to this 1997 law as new, but so many people have not sold a home and think of the old rules.
Instead, individuals can now exclude from gross income up to $250,000 ($500,000 for joint filers) of gain on the sale of a principal residence as long as certain ownership and use requirements are met. To qualify for the exclusion, the home must have been owned and used as a principal residence for at least two of the five years preceding the sale. For married couples filing a joint return, at least one spouse must meet the ownership test and both spouses must meet the use test to qualify for the full $500,000 exclusion. In addition, the exclusion can generally only be used once every two years.
If you fail the two year ownership and use test because of a change in place of employment, health, or unforeseen circumstances, a fraction of the excludable amount can be excluded. The Internal Revenue Service Restructuring and Reform Act of 1998 makes it clear that the fraction of the two year period that the property was owned and used, times the maximum excludable amount is used to reduce the gain.
For example, suppose Mr. Jones, a single taxpayer, satisfied the requirement in only one (rather than two) out of five years because of an employment-related move. His maximum exclusion would be $125,000 (one-half of the $250,000 limitation), regardless of the amount of gain.
Thus, if Mr. Jones had a gain of $300,000, he could exclude $125,000, not $150,000 (one-half of the $300,000 gain), and would pay tax on $175,000. On the other hand, if Mr. Jones had a gain if $100,000, he would pay no tax because all of the gain would be excludable, not just $50,000 (one-half of the $100,000 gain).
These new provisions provide opportunities for taxpayers who own multiple residences, who have already taken advantage of the once-in-a-lifetime $125,000 exclusion, or who prefer to downsize their home or to not buy a new home. But not everyone gets a better deal under this change. Sellers of any age having more than $250,000 or $500,000 of home profit will have to pay tax on the excess (at the applicable capital gains tax rate). The old law's rollover rule might have saved them the immediate tax. Also, owners who incur a loss on the sale of a home still can't deduct that loss. As always, it is recommended that you consult your tax advisor before taking any action.
Selling Your Main Home After the Death of Your Spouse
If your primary residence was titled in both your and your spouses names, Joint With Right of Survivorship, then at the first death of a spouse, the surviving spouse is entitled to a one-half step-up in basis of the property. For example: Let's say you and your spouse bought or built a home 25 years ago at a cost of $100,000. You made another $100,000 of improvements over the last 25 years by making an addition, adding a swimming pool and doing landscaping. Then at the time your spouse died, the property was valued at $400,000. Your adjusted basis would be calculated as follows:
1/2 of Original Cost $50,000 plus
1/2 Improvements made during ownership $50,000 plus
1/2 Fair Market Value at Date of Death $200,000
Adjusted Basis = $300,000
Based upon the above example, if you sold the home for $400,000, you would have a gain of $100,000 which would be excludable from income tax because it is less than the $250,000 exclusion available to the surviving spouse. It is important to note that although the gain is excludable, it is still reportable. That means you have to report it on your tax return and show the exclusion.