Selling - Tax Implications and Gains

Most homeowners are in a fairly good position these days. Nationwide, home prices have increased significantly in recent years - and in many cases, any profit from the sale of a home will be tax free.

Unfortunately, those who don't meet the home-gain exclusion requirements or sellers with truly substantial gains could be left out in the cold. Ditto for sellers aren't familiar with the tax-favorable treatment and could potentially miss out on tax-friendly moves.

But don't worry. Creative maneuvering can make the difference between a big tax hit and no hit at all. Keep reading for four tax-slashing strategies. But first it's important to review the rules that allow a home sale to be a tax-free transaction.

Gain Exclusion Basics

For federal income-tax purposes, an unmarried person will not pay taxes on the sale a principal residence for a profit of up to $250,000. That's correct, Uncle Sam gets nada. Married couples who file jointly are able to exclude up to $500,000. But to qualify, you must meet the following requirements:

1. Ownership requirement. You must have owned the property for at least two years during the five-year period ending on the sale date.

2. Residence requirement. You must have used the property as a principal residence for at least two years during the same five-year period.

At least one spouse must meet ownership requirement, and both spouses need to meet the residence requirement in order to be eligible for the larger $500,000 joint-filer exclusion.

Also, the $500,000 exclusion applies only when neither spouse has used the home-gain exclusion within two years of the sale date in question.

If you think you can't qualify, think again. Here are some strategies that could allow you to take advantage of this terrific tax break.

1. Get married for greater savings
That's right. Get hitched. If you're single and own a home that could be sold for a profit well above the $250,000 gain exclusion, you may want to do something drastic - like get married!

In all honesty, if you are already thinking about marriage, you nuptials will allow you to take advantage of the larger $500,000 joint-filer gain exclusion if you sell your home in the year you get married or in a later year. This could reduce your federal income-tax bill by as much as $37,500. Keep in mind: your savings are permanent and not just a timing difference.

This strategy may require some patience, because both you and your new spouse must meet the residence requirement, having used the home as your principal residence for at least two years. The good news: If your other half lived in the home before your marriage, you may be able to meet the two-year requirement.

2. Selling your home after a divorce
After a divorce, your ex-spouse might still live in the joint home while you may still own all or part of the property. Here's the bad part, after three years of being out of the house, you'll automatically be disqualified from the tax exemption. If this occurs you won't have any gain exclusion break to shelter your share of the profit. Therefore, you'll be taxed on 100% of your portion of the gain from the sale of the home.

The time to act is before the divorce. Careful planning may help you avoid losing the tax break. Make sure the agreement between you and your soon-to-be-ex states that the former spouse has permission to continue living in the home for whatever period is reasonable - five years, or until the youngest child graduates from high school, or whatever makes sense.

By stating this you will ensure that you are able to take credit for your ex-spouse's continued use of the home as his or her principal residence, and when the property is finally sold, you can claim a $250,000 gain exclusion assuming you meet the residence requirement. You will be eligible even though you haven't actually lived in the home for years.

3. Claim tax break for adjacent properties
The home-sale exclusion does not apply only to your residence. The federal government also allows home-sale gain exclusions from the sale of an undeveloped property adjacent to your house. In fact, you can do this even if the tracts of land are split into multiple sales.

In order to qualify, the land must: 1) be next to your residence and 2) have been used as part of your principal residence (as opposed to being used for business or rental purposes) for at the specified time. So the gain exclusion break can not be used for land you've always used for a cattle operation or equestrian farming. Additionally, you must sell the adjacent lot within two years of selling the parcel that contains your house.

Assuming you pass these tests, you can use your gain exclusion to shelter the combined profits from selling your residence and the parcels of adjacent land.

How much property can you liquidate under this loophole? According to the IRS, you can sell at least 29 acres and still receive the gain exclusion privilege.

4. Don't sell your appreciating home
You may want to reconsider selling your home if you are fortunate enough to own a hugely appreciated home. Selling could trigger a taxable gain far more than your gain exclusion break. You may simply want to stay in your home, if possible.

For example, you and your spouse own a home worth $3 million and you have lived there for many years. Your tax basis, the original cost plus the cost of improvements, is only $700,000. If you sell the home, you could face an amazing $1.8 million taxable gain even with the $500,000 exclusion. The combined federal and state capital gains tax will most likely be at least 20%, which is $360,000.

You get a much better tax result by keeping the home for the rest of your life. Then when either you or your spouse passes away, the tax basis of the deceased spouse's share of the property is elevated to the fair market value at the time of the death. The surviving spouse then can sell the home using the $500,000 joint-filer gain exclusion (using the stepped up tax basis) if the sale takes place during the year of the first spouse's death. Using the stepped-up basis rule makes the profit sheltered by the gain exclusion break. If the home is retained through the remaining spouse's death, the tax basis of that person's share is stepped up as well. The heirs can then sell the property and owe next to nothing in capital gains taxes.