Establishing Tax Basis in Personal Residence: Ten Reasons Why Records Should Be Maintained.

Author:Farmer, Larry E.

Discontinuance of Form 2119 (Sale of a Personal Residence) and the introduction of sections of the Taxpayer Relief Act (TRA) have led to the suggestion that homeowners can reduce their record-keeping chores. The implication is that few taxpayers will have to refer to records in determining income tax consequences of a personal residence sale.

Here we present ten reasons why this assumption is erroneous and why you should emphasize to your clients the importance of maintaining documentary evidence.

Possibility of Gains Being Taxed

Under certain conditions, all or part of a gain resulting from sale of a personal residence, may be taxed. Caps on gain exclusions, property usage tests and citizenship requirements may result in a gain being subject to taxation.

The law places a ceiling on the gain exclusion and the amount of the exclusion is filing status dependent. The general rule calls for a $250,000 gain exclusion, but can be as much as $500,000 on a joint return. A married couple would seemingly have little to worry about with a $500,000 gain exclusion. But circumstances do change and a once-married taxpayer, if divorced or widowed, will--when the property is sold--have the gain exclusion reduced to $250,000.

As time passes, what seemed like a large gain exclusion will erode with inflation. Considering an average inflation rate of 4 percent, the price of housing would be expected to double every eighteen years. Surrounding land use changes may increase the fair market value much faster than the inflation rate. Location of interstate highways and interchanges, emergence of large shopping malls, and presence of major employers have caused escalating prices in many real estate markets.

Either of two situations might substantially reduce the basis resulting in a taxable gain. First, any depreciation deduction taken on the property reduces basis. A house now serving as a personal residence may have gone through tax lives as rental property, commercial property, or partially served as an office. Second, rollovers of deferred gains under the previous personal residence sale rule reduce basis. Older taxpayers who have built up substantial rollover amounts through years of personal residence transfers could be entering into a taxable transfer when the current residence is sold.

In order to qualify for the gain exclusion, the law mandates a waiting period. A taxpayer is allowed to take advantage of the gain exclusion on only one sale every two years. Consider a case where the taxpayer meets the personal residence criteria in one house by living in it in 1997 and 1998. Without selling the first house, taxpayer buys another house and lives in it during 1999 and 2000. What happens when the taxpayer wants to sell both houses in 2001...

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