Tax Planning Tips - Tax Planning and Preparation

Exclusion of Gain on Sale of Principal Residence Not to Apply to Nonqualified Use

An individual taxpayer may exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned and used the residence as a principal residence for at least two of the five years ending on the date of the sale or exchange.

Under legislation passed in July, 2008, gain from the sale or exchange of a principal residence allocated to periods of nonqualified use is not excluded from gross income. The amount of gain allocated to periods of nonqualified use is the amount of gain multiplied by a fraction the numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer and the denominator of which is the period the taxpayer owned the property.

A period of nonqualified use means any period (not including any period before January 1, 2009) during which the property is not used by the taxpayer or the taxpayer's spouse or former spouse as a principal residence. For purposes of determining periods of nonqualified use, (i) any period after the last date the property is used as the principal residence of the taxpayer or spouse (regardless of use during that period), and (ii) any period (not to exceed two years) that the taxpayer is temporarily absent by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances, are not taken into account. The present-law election for the uniformed services, Foreign Service and employees of the intelligence community is unchanged.

Example 1--Married taxpayers buy a house for use as a vacation home on January 1, 2009 for $400,000. On January 1, 2011 they convert it to their principal residence. On January 1, 2013 they move out, selling the house on January 1, 2014 for $700,000. Fred and Sue meet the requirement of having used the house as their principal residence for 2 of the last 5 years, but they have 2 years of nonqualified use, from the purchase date of January 1, 2009 to the conversion date of January 1, 2011. Since the total holding period was 5 years and 2 of those years represent nonqualified use, 2/5 or 40% of the $300,000 gain ($120,000) does not qualify for the $250,000 ($500,000 if married filing joint) exclusion and is taxable as a long-term capital gain. The remaining $180,000 of gain is less than the maximum exclusion amount, so none of it is included in their income.

Example 2--Married taxpayers buy a principal residence on January 1, 2009 for $400,000. They move out of the house on January 1, 2019 and sell the property on December 1, 2021 for $600,000. The entire $200,000 gain is excluded from gross income, as under present law, because periods after the last qualified use do not constitute nonqualified use.

On a positive note, use before January 1, 2009 does not count as nonqualified use. Thus, if you were planning using this approach to exclude gain on your vacation home, it may still work, depending on your timing.

Note that the nonqualified use period could also result from the property being used as a rental or for business.

If any gain is attributable to post-May 6, 1997, depreciation, the exclusion does not apply to that amount of gain, as under prior law, and that gain is not taken into account in determining the amount of gain allocated to nonqualified use.

Dot.com AMT tax credit relief.

New relief is available for taxpayers saddled with unrecoverable AMT tax credits driven by the dot.com boom-bust. Based on the new rules, taxpayers may recover approximately 74% or more of their incentive stock option (ISO) related alternative minimum tax credits across six years, beginning in 2007. Individuals with credits totaling $31,250 or less may receive refunds for the entire sum. The new rules have exceptionally favorable consequences for taxpayers with hundreds of thousands of dollars in pent-up AMT credits. The maximum annual refund equals 20% of qualifying credits subject to certain requirements. Married taxpayers with incomes above $357,100 do not qualify for any refund. We recommend seeking tax advice to maximize this limited opportunity.

Zero Capital Gains Tax Rate.

Beginning 2008 through 2010, taxpayers age 24 and older with low incomes will qualify for a zero capital gains tax. The exemption applies to total taxable income below approximately $32,000. The exact figure will be released later this year. To reduce your tax exposure, evaluate gifting highly appreciated assets to adult children with taxable incomes under the qualifying sum.

Health Savings Accounts.

If you are healthy and make few trips to the doctor’s office, consider funding a tax deductible Health Savings Account or HSA. Account earnings and distributions for high-deductible health plans are tax free. Unused balances may accumulate without limit for future years. Maximum tax deductible contributions this year are $2,850 for single taxpayer health plans and $5,650 for family plans. An additional $800 contribution is allowed for taxpayers age 55 or older.

Hybrid Car Tax Credit.

If you're thinking of purchasing a hybrid vehicle, you may save between $250 and $3,150 on your federal income tax return. See a summary of the hyrbrid vehicle tax credits at Qualified Hybrid Vehicles . Keep in mind, the vehicle tax credit does not reduce your tax liability if you are subject to alternative minimum tax (AMT tax).

New Law Grants Registered Domestic Partners Same Filing Status as Married Couples.

Governor Arnold Schwarzenegger recently signed legislation that allows registered domestic partners to file their state tax returns using either "married filing jointly" or "married filing separate" status. The new law, which effectively gives registered domestic partners (RDPs are not necessarily of the same sex) tax treatment equal to that of married couples, went into effect in 2007.

Disaster loss election carryback .

If you suffer a casualty loss in a presidentially declared disaster area, you can either deduct the loss in the year it occurs, or carry the loss back to the prior year. Deducting the loss in the prior year can make sense if you were in a higher bracket (often the case). The deadline for making the election is the due date of your return, without extensions, for the year the loss occurs. For example, you had a $26,000 loss in 2007 from a fire or natural disaster. You can take the loss on your 2007 return or on your 2006 return by filing an amended return. But you must make the decision by the due date of your 2007 return, April 15, 2008.

Rent with option to buy . . . While not a standard clause in real estate rental agreements, it's not unusual. The owner receives a stream of payments for the option, avoids selling commissions and reduces risk of vacancy. For the renter it establishes a sense of certainty--- that at some point they’ll be able to acquire the home at a fixed price. After deciding on the purchase price and the option's value, its cost can be spread over the life of the lease in the monthly rent or an amount paid up front. To protect your interests, be sure to obtain competent legal, tax, and real estate advice

Capital Gain Distributions.

If you hold mutual fund shares for less than six months and sell at a loss, the loss is treated as a long-term loss up to the amount of capital gain distributions received on those shares. Losses in excess of distributions are treated as short term capital losses. This rule does not apply to losses on shares redeemed under a periodic liquidation plan.

Tax balance due?

If you are unable to pay a delinquent tax liability consider applying for an installment agreement with the taxing agency. Government financing will often result in lower monthly payments than debt financing through commercial lenders. Federal loan charges or assessments total 10.0% per year including late payment penalties. Annual charges for commercial unsecured debt can run between 18% and 24%.

Estate tax on income in respect of a decedent.

Did you receive income on account of an inheritance such as IRA or pension funds. If so, you’re required to include distributions in your taxable income. Keep in mind however, if the decedent’s estate was large enough to trigger estate tax, you’re entitled to a deduction for the tax attributable to your distribution. The estate’s executor should provide reporting details for the deduction.