Maximizing tax-free gain from a sale of a home.

• Author: Bakale, Anthony

Sec. 121, as amended by the Tax Reform Act of 1997 (TRA '97), provides a golden opportunity for taxpayers who may realize gain on the sale or exchange of their principal residence.

A principal residence is considered a personal-use asset. As a result, a loss on the sale or disposition of such an asset is not deductible, while a gain is subject to income taxation. Sec. 121 provides relief from this inconsistency. A portion of realized gain on the sale of a principal residence may be exempt from capital-gain tax.

Despite this, there are two caveats to the Sec. 121 exclusion rule. First, to qualify for an exclusion, a taxpayer must have owned and used the property as a principal residence for periods aggregating at least two years during the five-year period ending on the sale date. Second, if the taxpayer's realized gain exceeds the exclusion, the taxpayer must pay tax on the excess recognized gain, regardless of whether the taxpayer buys a replacement residence. The exclusion amount for a single taxpayer is $250,000; for a married couple filing jointly, it is $500,000, provided the couple meets the following requirements:

* Either spouse meets the at-least-two-years ownership requirement;

* Both spouses meet the at-least-two-years use requirement; and

* Neither spouse is ineligible for the Sec. 121 exclusion on the sale of the current principal residence because of a sale of another principal residence within the prior two years.

Tax Planning

Once a taxpayer has sold a principal residence under amended Sec. 121, the taxpayer has to calculate the taxable capital gain after considering the allowable exclusion. Each sale transaction, therefore, is taxed independently, with no need for perpetual recordkeeping.

Amended Sec. 121 provides an excellent opportunity for reducing taxes if a taxpayer does not mind selling and packing every two years.

Scenario 1: Using a Sec. 121 exclusion in conjunction with the sale of rental property. A taxpayer has a principal residence, which the taxpayer has owned and used for the past two years. The property has appreciated in value since the taxpayer purchased it. The taxpayer also has a rental residential property, purchased just a few years ago. For tax planning purposes, the taxpayer may want to take the following steps:

1. Sell the existing principal residence and benefit from the allowed exclusion under Sec. 121 (maximum $500,000, permanent capital-gain exclusion);

2. Move into the rental property and live...