Tax Considerations for key West Real Estate Sellers

Federal taxes on the sale of the real estate property

You do only if the profit on the sale is more than $250,000 ($500,000 for a couple.)

Determine the profits

You can calculate your profits by subtracting the adjusted cost basis of your home from its adjusted sales price. You can compute the adjusted cost basis by subtracting certain items such as the sales commission, lawyer's fees, and fix-up expenses from the price of your home when you bought it.

To calculate the adjusted sales price, start with the selling price. Then subtract the cost of capital improvements made while you owned the home and closing costs not deducted when you bought it. Note that you may not subtract the cost of repairs. The IRS is very strict about what it considers improvements. For example, repairing a water heater is not considered an improvement but adding a dishwasher is. Also, you may deduct the labor costs paid to a tradesperson (such as a carpenter) but not any costs for your own labor. The IRS requires home sellers to complete a form in the year of the sale that includes these calculations. You also will want to keep all receipts for any costs you are deducting from the sale. Without such written proof, the IRS is not likely to allow your deductions.

Determine the taxes

First, remember that if there is no profit, you do not have to worry about paying taxes; however, the IRS does not allow you to deduct any loss on a primary residence. Until May 7, 1997, homeowners who sold their house could defer payment of capital gains tax by rolling the proceeds of the sale into a new house--but only if the new house cost more than the old one did. Then, after age 55, when they were probably in a lower tax bracket and ready for a smaller home or retirement community, each person was entitled to exclude up to $125,000 in profit--but only once. Because of these rules, many families bought bigger, more expensive houses than they needed, especially if they moved to an area with lower real estate values.

All this changed in 1997 with a new tax law. Now, you don’t have to pay capital gain on the sale of any residence you’ve lived in for at least two of the last five years, unless the profit is more than $250,000 per person or $500,000 per couple. You have to count not only the profit on this house but on any other houses you sheltered by rollover prior to 1997. If special circumstances meant you had to move before living there two years, you can exclude part of the profit--for instance, half the profit if you lived there only one year, up to your $250,000 limit.

This change means that most people won’t have to pay capital gains taxes at all on their home, unless they’ve racked up enormous profit. And you can exclude capital gain on sale of your residence as many times as you wish. Note that this door doesn't swing both ways. If you lose money on the sale of your home, you can't deduct the loss and pay less in taxes.

The capital gains exclusion doesn’t apply to investment properties and vacation homes. However, people with more than one home can avoid tax on each of them with a little planning. For instance, if you have a condo in New York City and a house in Florida, you could make the New York home your primary residence for two years before selling it, then make the one on Florida your primary residence for two years before selling it. For a house to count as your primary residence, you have to live there for 183 days each year.

Win or lose, whenever you sell a home you have to file Form 2119, reporting the sale date, the price and how much profit is subject to immediate taxation, if any. This one-page form takes you through the calculations required to determine gain on sale, adjusted sales price, and taxable gain. If you die without selling the home, all capital gains taxes are wiped off the slate. Your beneficiaries will inherit it at a new, stepped-up basis, and they don't have to pay any tax on capital gains accumulated on the sale of your home or homes over the years.

What if you own a duplex, live in one unit and rent out the other? In that case, you can only avoid capital gain on the half you use as your residence. The other is a business property, not subject to this tax break.

Save your receipts, because eventually your house just might gain enough in value that you’ll want to prove that your basis has increased and therefore the profit isn’t as great as it appears. For details on IRS regulations in this area, see Publication 523, "Selling Your Home."

State and local taxes on my real estate profits

It depends. You may live in a state or city that will require you to pay state or local taxes on the profits of a home. Some states or local communities also charge a "transfer tax" on the sale of property. This tax is usually levied as a percentage of the sales price.

Sale-leaseback

A sale-leaseback occurs when you agree to sell your home to a buyer who agrees to rent the home to you for a certain period of time. Usually, this type of arrangement occurs between retired parents and their adult children. A sale-leaseback often provides the most advantages to retirees in low tax brackets who have children in high tax brackets. The family can structure it so that the children carry the burden of paying interest and take the benefit of deducting the interest from their taxes. The parents benefit by receiving income to offset expenses.

The sale-leaseback can be established in two ways. Either the buyer can obtain a loan to buy the home outright or the seller can provide some of the financing. In the first case, the seller would pay rent to the buyer. In the second case, the seller would pay rent to the buyer while the buyer would make payments to the seller on the loan given by the seller.

If you are considering this arrangement between relatives, be sure to have your agreement in writing and make sure that it conforms to IRS rules. For example, the IRS requires that the buyer pay a fair market price for the home and that the seller pay a fair market rent in order for the arrangement to avoid qualifying as a gift. In other words, the IRS will not permit you to structure a sale-leaseback to lower your estate taxes. An attorney can help you draw up the necessary papers to make sure you don't inadvertently run afoul of the IRS rules and end up with a penalty or gift tax. See the chapter in this book on older Americans for more on sales-leasebacks, reverse mortgages, gift annuities, and other options of particular interest to older persons.