When a home sale could result in capital gain

Given the current economic situation, a taxpayer selling their home may not be a frequent occurrence, but tax preparers should still be vigilant. It’s all too easy to look a the current mortgage rules – exempting the first $250,000.00 to $500,000.00 of capital gain – and forget that these rules have only been in force since May, 2007. Prior to May 2007, the old rules – allowing a deferral of gain, provided reinvestment of the funds within two years – were in effect.

Let’s see how forgetting that fact can have an impact:

X, a single homeowner, buys her home in May, 1986 for $100,000.00. In October, 1996 X sells her home for $200,000.00, and files form 2119 to defer the $100,000.00 capital gain. At the same time, X buys her new home, for $225,000.00.

In 2008, X sells her home for $460,000.00, and heads down to Harry’s Tax Service to have her taxes prepared. Harry dutifully notes that the cost basis of the home was $225,000.00, the sales price is $460,000.00 and the capital gain is $460,000 less $225,000.00, or $235,000.00. Since the $235,000.00 capital gain is less than the $250,000.00 exemption, Harry claims no capital gains tax.

Sadly, Harry’s wrong, because X’s house was purchased under the old rules, and under the old rules, the basis of the new home must be reduced by any capital gain deferred. Thus, X’s basis in her home isn’t $225,000.00, but $225,000.00 less the deferred gain of $100,000.00, or $125,000.00.

Revisiting the earlier transaction, X’s capital gain is now $335,000.00, or $85,000.00 over the $250,000.00 exemption amount. X might not be happy to hear that she owes capital gain tax, but it’s better you tell her while preparing her return, then having her show up in your office with a CP2000 letter telling her she has a balance due of not only the capital gain tax amount, but the refund that she received!