Capital Gains Taxes Can Take a Bite Out of Home Sale Profits

2/8/2006

In today's housing market, with prices still strong in parts of the country, people continue to search for fixer-uppers to buy. There are two reasons to buy a house that's in less than perfect shape: Either to fix it up and move in, or to fix it up and sell it for as big a profit as possible.

There are plenty of lenders who will help you get the mortgage to both buy this type of house and to fix it up. Before you do, however, make sure that you understand the income tax rules and regulations that will apply if and when you sell the property.

If this will be your only home and you will live in it during the rehab, you can get a normal mortgage. In fact, the FHA offers special fixer-upper or rehabilitation mortgages. Often referred to as 203(k) loans, they will let you finance both the cost of the home and the cost of fixing it up. You can even use a 203(k) loan to convert a single-family home into a duplex, triplex or four-plex.

With a 203(k) mortgage, you can either hire a contractor to do the work, or do it yourself. In fact, many people see the phrases some work required, needs refurbishing, or home handyman special as an opportunity to add tens of thousands of dollars to the value of the home through sweat equity -- meaning they do the work themselves.

If, however, the property is a second home, you will have to pay a higher interest rate, and probably make a larger down payment, because the requirements for mortgages on second homes are more stringent than for first ones. The loans are riskier. Let's face it, if a two-home family gets into a financial bind and one of the homes has to go, they are more likely to fall behind on payments or give up the second home than they are to relinquish the first one.

As we all know, there are some major tax advantages to buying and paying for a house, primarily the mortgage interest deduction. There can be some disadvantages in selling, however, explains CPA Ken Weir, of Weir & Associates in Bakersfield, Calif. Another way to pronounce disadvantage is capital gains tax.

While you can deduct the mortgage interest from both your principal and a second, or vacation, home, the rules change when you sell one of them. Individuals may exclude up to $250,000 of the gain from the sale of a principal residence, Weir says. A couple can add their exclusions together and deduct $500,000, but only if the property is in both of their names.

To qualify for this exclusion, the taxpayer or taxpayers must have used the property as their principal residence for two out of the last five years prior to the sale," he add. The taxpayer must still meet the two-year principal residence rule even if the property was held less than five years.

In order to keep as much of the profit as you can, there are a couple of things you must do. The first is to have owned the home for at least two years and made it your principal residence. We'll look, a little later, at what happens when you sell after less than two years. Does claiming it as your principal residence mean that you have to live in it for the full two years? No. What it means is that it has to be where you lived for most of the two years that you are claiming to have lived there. What is most? Talk it over with your financial advisor or tax preparer.

How do you prove that you've lived there most of the time? It's pretty basic. What address did you have on your driver's license during that period? Where did you get your mail? Where did you vote? If you have kids, where did they go to school? Is it near where you worked at the time? If it is in a different state, what license plates did you have on the car? Which state considered you a resident? If you can show that it was your principal residence for two of the last five years, then you can claim the capital gains break.

Now, let's look at the alternatives. Weir says there are two sets of tax rules. There is one set for holding-or claiming it as your principal residence-for less than one year, and a different set if you claim it for more than one year but less than two.

If the taxpayer held the property for less than 12 months, any gain from the property would generally be treated as a short-term capital gain and would be taxed at the taxpayer's or taxpayers' regular tax rate.

That profit, however, could very likely push the seller into a much higher tax bracket which would then apply to the seller's or sellers' total income and not just the profit from the house.

If, however, you hold onto it for more than one year but less than two, Weir says, The gain from the property would generally be treated as a long-term capital gain and be taxed at either 15 percent or 25 percent at the federal level, depending upon the taxpayer's income. And if you never lived there, normal long- and short-term capital asset holding rules apply, just like they do for many other investments.

The simple fact is that if you sell before the two-year limit, you will wind up paying a capital gains tax; however, you'll still walk away with a sizable portion of the profit.

Many people think that buying a fixer-upper is a quick way to make a buck. It just may be, if you're willing to put out the time, effort and expense to do it. Just keep in mind that making that buck can be a lot more complicated than just slapping a coat of paint on the walls and pounding a For Sale sign into the front lawn.