When you’re thinking about whether to move or stay in a home, your laundry list of considerations should include the tax implications. Generally speaking, when a residence is sold, a capital gains tax is levied on the gain from the sale. The capital gain is the difference between the purchase price and the sale price. For example, if you buy property for $100,000 and sell the property one year later for $150,000, a 20 percent tax is levied against the $50,000 gain. This creates a capital gains tax equal to $10,000. Additionally, if you lived in a state with income tax, the state may levy an additional tax upon the gain.
But, there is an exception to the capital gains tax. If, when you are selling your home, you have lived there for at least two of the last five years you may not have to pay capital gains tax (Internal Revenue Code Section 121(a)). Under this exception, an individual can exclude $250,000 of capital gain. If a person is married filing jointly, they can exclude $500,000 of capital gain. Since most people stay in their homes at least two years before selling, and typically the sale price is not $250,000 ($500,000 if married filed jointly) more than the purchase price, the sale is usually exempt from capital gains tax under Code Section 121(a).
What happens though if the unexpected happens and a sale occurs less then two years after the purchase? Under Treasury Regulations, there are certain safe harbors if an unforeseen event – like a death or divorce – occurs that exclude a portion of the gain. And recently, the IRS issued a private letter ruling (PLR 201628002) that allowed a couple with a second child eligibility for a reduced maximum exclusion of capital gains based on a pro rated formula, even though they did not meet the safe harbors in the Treasury Regulations. The couple owned a small two bedroom condominium. The first bedroom was used by the couple. The second bedroom was a combination nursery, home office, and guest room. The arrival of a second child meant the family needed to move. The IRS agreed the couple’s unforeseen circumstance (the arrival of the second child) was enough to exclude a portion of the capital gain.
What is important to note is that private letter rulings are directed at specific taxpayers. They are not blanket safe harbors. Therefore, other taxpayers with similar circumstances need to apply for a private letter ruling and cannot solely rely on this private letter ruling. This particular ruling is important though, because it provides guidance to taxpayers in similar circumstance that the IRS may again provide a safe harbor for a family that has to move because of the expansion of their family.
In reviewing the laundry list of pros and cons on whether to move, the length of time in a residence is important. Remember – if it has been over two years, then capital gains taxes will not apply for gains under $250,000 ($500,000 if married filed jointly) and the sale will not be subject to capital gains taxes.