TAX RULES ON SALE OF PRINCIPAL RESIDENCE
By: Roman P. Mosqueda, Esq.
In the September 8-10, 2004 and November 10-12, 2004 issues of the Los Angeles Asian Journal, this author wrote the articles entitled “Exclusion of $250,000/$500,000 From Gain on Principal Residence Sale” and “Why You Should Own Your Home.”
Those articles discussed the capital-gain exclusion of $250,000 for single person and of $500,000 for married and jointly filing couples. This article further discusses capital-gain exclusion and California’s withholding requirements and exemptions thereto on the sale of real property in California.
Capital gain simply means profit generated from the sale of a property. The taxpayer is taxed on the excess of the capital-gain exclusion at generally 20 percent by federal income tax law. California does not have capital-gain tax, aside from state income tax.
The formula to obtain capital gain is adjusted selling price (selling price less expense of sale) minus adjusted cost basis (cost of acquisition plus capital improvement less depreciation [only for income, trade or business property]).
California requires a withholding of 3-1/3 percent of the sales price of real estate in California, unless the taxpayer is entitled to exemption, as discussed below:
Act Of 1997:
Signed into law by President Clinton on August 5, 1997, the Taxpayer Relief Act of 1997 eliminated the old rules on the sale of a principal (or personal) residence.
It repealed the two-year rollover requirement (Section 1034 roll-over statute on reinvesting sales proceeds in another home within 24 months) and the once-in-a-lifetime 55-year old, $125,000 tax-free gain rule (old Section 121 of the Tax Code on one-time exclusion of $125,000 capital gains for 55-year-old or older taxpayers).
Effective for sales of principal residences after May 7, 1997, a single taxpayer can exclude capital gains up to $250,000, and a married couple filing a joint income tax return up to $500,000, provided that:
1. the taxpayer(s) must have owned the home and lived in it as primary residence for at least 24 months (2 years) out of the prior 60 months (5 years);
(a) if married-joint filers, either spouse must have owned the home for two of the last five years prior to the sale or exchange,
(b) both spouses must have used the home as their principal residence for two of the last five years, and
(c) neither of the spouses must be ineligible because another sale or exchange was made during the previous two years for which the exclusion was used; and
2. the capital-gain exclusion is used only once in any 2-year period, but:
(a) there is no limit on the number of times this exclusion is available, and
(b) there is no age restrictions on the use of this exclusion.
But even if one of the requirements is not satisfied, a husband and wife may still be eligible for the $250,000 exclusion. For example, if one year after the marriage, a wife sold her house acquired before the marriage, which she had owned and used for at least two years prior to the sale, she meets the two-year ownership and use requirements.
Thus, both wife and husband can use the $250,000 capital-gain exclusion in their joint income tax return, even if the husband does not meet the aforesaid two-year ownership and use requirements.
A homeowner who rents out his or her home can count the period of tenancy to satisfy the ownership requirement. And a tenant who subsequently purchases the home he or she has been renting can count the period of tenancy to satisfy the two-year use requirement.
Thus, a rental or income property converted by its owner to a principal residence and sold after May 7, 1997 is eligible for the capital-gain exclusion subject to the two-year rules stated earlier. But any depreciation for income, trade or business property taken after May 7, 1997 remains taxable at a 25 percent maximum tax rate, even though the property is converted to a principal residence.
Significantly, the Taxpayer Relief Act of 1997 allows prorata capital-gain exclusion to taxpayers for sales that are less than 2-years apart, or for failure to meet the 2-year rules because of health, change of employment, or other unforeseen circumstances such as death, divorce or loss of job specified by the Treasury Regulations. For instance, one-year residence or second sale after one year still entitles the taxpayer to 50 percent of the capital-gain exclusion.
For Sale of California
Section 18662 of California’s Revenue and Taxation Code may require a buyer to withhold through an escrow company an amount equal to 3-1/3 percent of the sales price in the case of a disposition of California real property interest, subject to penalty for failure to withhold in an amount equal to the greater of 10 percent of the amount required to be withheld or five hundred dollars.
A. Amendments Effective
January 1, 2005:
California’s Assembly Bill 1338 amends Revenue and Taxation Code Sections 18662 and 18668, making changes to real estate withholding requirements and exemptions effective for all transactions closing on or after January 1, 2005. The main changes are: it
(1) replaces the waiver process for non-individuals with a self-certification process. Although non-individuals will not be able to request reduced withholding on small gains, they will be able to self-certify that they are exempt from withholding if they will have a loss on the sale, are doing a Tax Code Section 1031 exchange, or the property is being involuntarily converted and the seller intends to replace it to meet the requirements of Tax Code Section 1033;
(2) expands the exception for the sale of a principal residence to include sellers whose “last use” of the property sold was their principal residence even though they do not meet the “two out of the last five years” requirement or one of the special circumstances;
(3) clarifies that no withholding is required when the transferee acquires the property: at a sale pursuant to a power of sale under a mortgage or deed of trust, at a sale pursuant to a decree of foreclosure, or by a deed in lieu of foreclosure;
(4) expands the exemption for the sale of a principal residence to include sales by estates when the property was the decedent’s principal residence;
(5) does not provide for an exemption for irrevocable trusts that have a California resident trustee; and
(6) does not provide for an exemption for estates when the decedent was a California resident.
Real estate withholding is a prepayment of California state income (or franchise) tax due on the capital gains for sellers of California real property, similar to wage holding by employers. California recognizes federal capital-gains exclusion, and taxes only the excess after deducting the exclusion as regular state income tax.
Withholding is required on sales or transfers of California real property with total sales price exceeding $100,000. It is not required on foreclosure sale, and when the seller qualifies for a full exemption.
B. Exemptions From
Sellers are exempt from the withholding requirements if:
(1) the real property qualifies as the seller(s)’ principal residence per Section 121 of the Tax Code (during the five-year period ending on the date of sale, the sellers have owned and lived in the property as their main home for at least two (2) years, subject to the exemptions stated herein);
(2) the last use of the property being sold or exchanged was used by the sellers as their principal residence within the meaning of Section 121 of the Tax Code;
(3) the California real property being conveyed is or will be exchanged for property of like kind, under Section 1031 of the Tax Code;
(4) the California real property has been compulsorily or involuntarily converted within the meaning of Section 1033 of the Tax Code and the seller intends to acquire property similar or related in service or use so as to be eligible for non-recognition of gain for California income tax purposes under Section 1033 of the Tax Code; and
(5) the California real property transaction will result in a loss or net gain not required to be recognized for California income tax purposes.
Withholding is required unless the sale qualifies for automatic exemption:
(1) total sales price of the property is $100,000 or less;
(2) the transferor is a bank acting as trustee other than a trustee of a deed of trust; or
(3) the transferor is acquiring the property as part of a foreclosure sale.
Sellers who meet any one of the exemptions must sign a written certification (Form 593-C) under penalty of perjury. The escrow company must keep this form in its files for five years following the close of escrow. It is not sent to the Franchise Tax Board unless requested.
These favorable tax rules on sale of principal residence should encourage, not discourage, home ownership in California.
(The Author, Roman P. Mosqueda, is a real estate broker and a real estate attorney in California.)