‘97 Federal Tax Law Eases Capital Gains Penalty

The deal is done. The political gaming is over. And after half a year of uncertainty, home sellers, buyers and real estate investors finally can tote up the score to see whether they’ve emerged winners or losers under the 1997 federal tax bill.

Here’s a quick rundown of the final compromise version of the legislation, along with answers to some practical questions you may have about the law.

* Capital gains: The new legislation completely scraps the traditional system of “rollover” deferrals of tax liability on home sale profits. It also terminates the complex $125,000 onetime tax-free “exclusion” on profits for home sellers 55 or older.

In its place the legislation substitutes a much simpler system that will allow the vast majority of taxpayers who sell their principal residences on or after May 7, 1997, to escape federal capital gains taxes on their profits.

Married home sellers who file their federal taxes jointly will be able to take up to $500,000 in home sale gains, tax-free, provided they used the property as their principal residence for two of the prior five years.

Taxpayers who file singly--even if they’re married--will be able to take up to $250,000 profit without capital gains taxation.

What about people who closed on a home sale before the May 7 effective date? They’ll be covered by the rules--the rollover and the $125,000 exclusion--in effect before enactment of the 1997 law.

What about seniors who have already made use of the onetime $125,000 exclusion? They’ll be free to make full use of the new law, provided they meet the two-year principal residence test.

How often can sellers make use of the new rules? As often as once every two years, assuming they have gains.

Will the new law allow empty-nesters with sizable capital gains, or corporate employees who must move from high-cost to low-cost housing markets, to buy smaller, less expensive homes without tax penalty? Absolutely. That’s the whole point of streamlining the system: to allow people to choose the type of housing they want--including renting, not owning--without worrying about the tax consequences.

What if sellers have gains that exceed the $250,000 or $500,000 limits? Any gains you have above the limit will be taxed at the new 20% capital gains rate, down from the current 28%.

Beginning in 2001, home buyers who occupy their homes for more than five years may qualify for an even lower capital gains rate--18%--on gains above the statutory limits.

* Capital losses on home sales: Though there had been efforts in both the House and Senate to permit home owners who sell their properties at a net loss to take a capital loss deduction, the final package carries no relief for such sellers.

* Individual retirement accounts: The final package allows penalty-free early withdrawals of up to $10,000 from an IRA to help with the down payment on a first-time home purchase. The IRA can be the home purchaser’s own account or can be a parent’s or grandparent’s. Under previous law, early withdrawals incur a 10% federal penalty on top of the IRA holder’s regular income tax rate.

* Home office deduction liberalization: Under the new law, thousands of self-employed taxpayers who run their businesses from their homes but who perform most of their business services outside the home will be able to deduct the costs of maintaining their office space as a business expense. The effective date of this provision won’t be until 1999, however.

* Depreciation “recapture” for investment real estate: House and Senate conferees agreed on a 25% rate for recapture of depreciation deductions for investment and business real estate.

Taxable gains on sales of investment property attributable to an increase in the sales value of the property will qualify for the new 20% capital gains rate. For sellers whose principal tax liability is for repayment of the depreciation write-offs they took, the 25% rate represents only a minimal improvement from current law, under which their depreciation recapture rate is 28%.

* Tax-free real estate exchange cutbacks: Though the Clinton administration sought to limit the use of this increasingly popular technique, neither the House nor the Senate went along. The tax-free exchanging rules remain intact, allowing savvy investors to pay no tax when they swap property that’s increased in value for “like kind” real estate.

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Distributed by the Washington Post Writers Group.