The Tax Rules for Sale of A Personal Residence

The Taxpayer Relief Act of 1997 brought sweeping changes to the tax rules applicable to the sale of a personal residence. Gone are all of the old rules, including the two-year rollover requirement and the once-in-a-lifetime 55-year old $125,000 tax-free gain rule. These rules were completely repealed.

Effective For Sales After May 6, 1997, The Rules Are -

A $500,000 tax-free gain for married-joint filers and a $250,000 for single persons. However, any depreciation taken on the residence after May 6, 1997 is subject to tax at the capital gains tax rates (maximum of 25% capital gains tax rate).

1st Two-Year Rule - Must live in residence for any two out of prior 5 years.

2nd Two-Year Rule - A second home sale within a two year period is not eligible for this exclusion.. Can only use this exclusion once in any two year period.

Except for the 2-Year Rules, no limit on number of times this exclusion is available.

A residence which was originally acquired as replacement property in a 1031 Exchange must be owned for five years as well as lived in for two out of those five years to qualify (American Jobs Creation Act of 2004).

A prorata exclusion is available for taxpayers for sales which are less than two years apart, or for failure to meet either of the two-year rules due to change of employment, health or other reasons specified by Treasury Regulations. For instance, one year residence or 2nd sale after one year = 50% of the above referenced exclusion.

A rental property converted to a personal residence and sold after May 6, 1997 is eligible for this exclusion subject to the two-year rules. Only the depreciation taken on the property after May 6, 1997 is taxable even though the property was partially or fully depreciated prior to May 6, 1997 before it was converted to a personal residence.

Taxpayers with a gain exceeding these exclusion amounts get no relief and must pay tax on the excess amount at the maximum capital gain tax rate; 15% generally except for the 25% maximum rate applicable to any depreciation taken on the residence after May 6, 1997.

There are a number of 1031 exchange strategies that investors can use in conjuction with the primary residence rules. For a sample of one such option, visit additional primary residence strategy guidelines on 1031 Exchanges.