What Are the Recent Changes to Real Estate Capital Gains Laws?

In May 2006, President George W. Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005. The measure extends to 2010 the reduced tax rate of 15 percent on long-term capital gains for taxpayers in the 25-percent or higher tax brackets and five percent for individuals in the 10-percent or 15-percent income tax brackets. Without further action, the rates will jump by five percent in 2011.

In real estate transactions, owing capital gains tax depends on the use of the property and the length of time you have owned the property before selling. Gain from a property bought and sold within one year is taxed as ordinary income and can be taxed at the maximum rate of 35 percent. To benefit from the reduced tax rates, property must be held for more than one year.

How to minimize the tax impact

There is a way to avoid paying capital gains tax on a home sale altogether. Since 1997 when Congress passed the Taxpayer Relief Act, single homeowners can make up to $250,000 profit (twice that if married) on the sale of their principle residence without paying taxes. This rule replaces the pre-1997 rollover provisions allowing homeowners to defer gain on the sale of a house if a new residence was purchased within two years from the sale date.

Under the new rule, to exclude gain you must have owned and lived in the property as your main home for at least two years of the last five years before the sale. If the house is an investment property, then regular capital gains rules apply. However, you can make investment property eligible for the exclusion by living in it for at least two years, which do not have to be continuous. Also, there are certain safe harbor provisions that allow sellers who do not meet this test to qualify for the exclusion. IRS Publication 523 offers guidance regarding the application of the ownership and use tests.

Another way to minimize tax consequences from the sale of investment property is to do a like-kind exchange, or Section 1031 exchange. Under this provision of the tax code, no gain or loss is recognized if you exchange business or investment property solely for business or investment property of a like-kind. Note that real property in the U.S. and real property outside the U.S. are not like-kind properties for tax purposes.

Before considering any real estate investment, it's a good idea to seek tax advice and plan on a long-term, rather than a short-term, commitment.