Buying vs. Renting in Golden State
You’ve been a renter your entire life. It’s not that you haven’t had the means. It’s simply been cheaper to rent than buy in the Bay Area. The tides have changed. Recent statistics show that home ownership is now more affordable than renting in all but 2 of 100 major metro areas. Wanting to capitalize on the recent rise in inventory in some areas and historically low interest rates, you decide it’s time to invest in some Golden State real estate. To properly plan, you should understand how you’re impacted by the 2013 California real estate tax law and federal tax law rules concerning home ownership. Specifically, how does the home ownership exclusion work under 2013 California real estate tax law?
Homeowners Exclusion Rules under 2013 California Real Estate Tax Law
One of the most valuable and widely misunderstood tax deductions available to homeowners is the “homeowners exclusion.” It’s not as straightforward as it seems. The following points will help you to understand how to utilize the homeowners exclusion under 2013 California real estate tax law.
Married vs. Single Exclusion Amount
The exclusion amount differs for single and married persons.
Single homeowners can exclude the entire gain on the sale of a home up to $250,000.
Married owners can exclude $500,000 if:
- They file a joint return for the year
- Either spouse meets the ownership test
- Both spouses meet the use test; and
- Neither spouse has recently excluded a gain from the sale of another home after May 6, 1997 (see below).
If either spouse does not satisfy all these requirements, the exclusion is figured separately for each spouse as if they were not married. This means both spouses may qualify separately for part or all of the $250,000 exclusion under 2013 California real estate tax law.
3 Tests to Qualify for “Home Ownership”
Home owners need to meet the “ownership, use, and waiting period” tests to qualify for the exclusion under 2013 California real estate tax law.
- Ownership: Seller owned the home for at least two years of the five year period before the closing date.
- Use: Seller used the property as a principal residence for two years of that five year period.
- Waiting Period: The exclusion wasn’t used during the preceding two year period.
A confusing concept of the exclusion is the fact that ownership and use of the “home” (co-op apartment, condominium, mobile home) can occur at different times. If you rent a home that you later live in as your primary residence you may pass the “use” test but not the “ownership” test.
No Limitations on Use
There is no limit on how many times the exclusion can be used. For instance, married sellers may exclude up to $500,000 of gain on each home sale made during their lifetime, provided the other California real estate tax law rules are met.
Capital Rate Taxation
The 2013 California real estate tax law rules concerning capital gains on sale of long-term assets hasn’t changed since January 1, 1998. Since that time, gains from all long-term capital assets (i.e. homes) are taxed at the rate of 20%, or 10% for taxpayers in the 15 percent tax bracket. Recent changes in the law now impose a surtax of 3.8% on gains under certain conditions.
What does this mean? Tax savings. If sellers qualify for the exclusion, the first $250,000 (single) or $500,000 (married) of the gain on the sale isn’t taxable. Any gain above $250,000/$500,000 is taxed at the capital gains rate and not higher ordinary income tax rate.
Pro Rata Reduced Exclusion Amount Situations
The California real estate tax law scheme grants reduced exclusion amounts for people who otherwise meet the “ownership” and “use” tests, but sell their home before the requisite 2 year period due to job transfer or health problems.
- A married couple “owns” and “uses” property for 6 months out of a 2 year period. The couple can exclude 25% (6 months is 25% of 2 years) of the total exclusion amount, or $125,000, if they moved due to job transfer or health problems.
Qualification if Not Living at Home
You don’t have to be living at the home at the time its sold to qualify for the exclusion under 2013 California real estate tax law. The two years of ownership and use may occur any time during the five years before the date of the sale. This means you can move out of the house (and rent it out) for up to three years before selling and still qualify for the exclusion. Likewise, you can be eligible for the full exclusion if you move into the rental property for 2 years and convert it to your principal residence. Why is this important? You may be able to invest in other property tax-free through a 1031 exchange.