Legal Line Question of the Week: The Capital Gains Tax Exemption

The Capital Gains Tax Exemption 

Question: I have been speaking to a seller about representing her in the sale of a residential property. The seller has owned the property and used it as her primary residence for one year and nine months. The seller has indicated that she cannot sell until she has owned the property for at least two years. What is the importance of the two year time frame?

Answer: The two year time frame that the seller is referring to relates to the way that the &quotgains&quot on the sale of the property is taxed for income tax purposes. In general, income is taxed differently depending on how it was earned. Income is generally taxed either as a long term capital gain or as ordinary income. Long term capital gains are taxed at a preferential rate as compared to ordinary income. The profit from the sale or exchange of a property is a capital gain. On the other hand, ordinary income includes salary, wages, commissions, etc. Thus, after selling a home the amount gained on the transaction is usually taxable at the preferential long term capital gains rate.

Additionally, if the home seller owned the home for at least two years before making the sale, he or she may be partially or totally exempt from paying the capital gains tax. According to the Internal Revenue Service (&quotIRS&quot), a taxpayer may automatically exclude the first $250,000 gained from the sale (or the first $500,000 gained if filing with a spouse) if the following are true of the transaction:

  1. The taxpayer owned the house and used it as his or her primary residence for at least two of the five years preceding the sale;
  2. The home was not acquired in a 1031 Exchange during the past five years; and
  3. The taxpayer has not claimed any exclusion for the sale of a home in the two years prior to the current sale.
For example, if your seller waits for the two year period and then sells the property for a gain of $600,000, only $350,000 would be subject to the capital gains tax. The other $250,000 gained on the sale would fall into the exemption and the seller would not have to pay any capital gains taxes on this amount. 

Important Tip Real estate licensees cannot provide legal or accounting advice.  Accordingly, real estate licensees should always recommend that the parties they are representing speak with their own accountant, tax advisor and/or attorney in order to ascertain the exact tax consequences of a particular transaction.

By; Neil B. Garfinkel, 
REBNY Broker Counsel
Partner-in-charge of real estate and banking practices at Abrams Garfinkel Margolis Bergson, LLP


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