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Avoiding a Capital Gains Tax on the Sale of Your House

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By Tom Herman, The Wall Street Journal Online

RISMEDIA, August 16, 2007—(WSJOnline.com)—Question: We bought a home in California in May 2001. In May of this year, we sold that home for a $175,000 profit. In December, 2004, we bought an Arizona vacation/rental home while maintaining the California home as our main residence. We now are leasing another California home. Do we need to do anything — such as buy another house within two to three years — to avoid a capital-gains tax? –T.R. and L.R., Lincoln, Calif.

Answer: No. You don’t need to buy another house to qualify for a federal tax break on the sale of your home. Based on what you’ve told me, you shouldn’t owe Uncle Sam any capital-gains tax on that $175,000 gain you made on the sale of your California home.

Under a law enacted about 10 years ago, a married couple filing jointly usually can exclude as much as $500,000 of their gain. For someone who is single or married and filing separately, the limit is $250,000.

To qualify for the full exclusion, you typically must have owned the home — and lived in it as your primary residence — for at least two of the five years prior to the sale.

This exclusion applies only to your primary residence. You easily met the two-year requirements. But even someone who couldn’t pass those tests might qualify to exclude most or all of the gain under certain circumstances. The seller may be eligible for a reduced exclusion if that person had to sell because of a “change in place of employment,” health reasons or “unforeseen circumstances.”

What are unforeseen circumstances? Examples cited by the Internal Revenue Service include divorce, death, or “multiple births resulting from the same pregnancy.” For more details, see IRS Publication 523.

Many other readers over the years have raised similar questions. Some think they’re required to buy a new home to qualify for this home-sale gain exclusion. That’s wrong. They’re probably thinking about a law that was repealed about a decade ago, under which you could defer tax on the gain on the sale of your home by rolling over the proceeds into a new home that cost as much as, or more than, the old one.
Congress eliminated that law, in part because it was viewed as unfair to people who wanted to downsize and buy a less-expensive home or to sell and move into a rental.

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