February 13, 2005 08:20 AM
Taxed On Our Gains
Excerpt: But the new regs are a lot more lenient. Essentially, home-sale profits of up to $250,000 for single persons and as much as $500,000 for married couples are excluded from taxable income no matter what you do with those gains.
We sold our home in Los Angeles for a profit of $85,000, moved to Kansas and are now looking to purchase a new home. My husband says we should put as little as possible of our home-sale gain toward the down payment, but I'm worried we'll get taxed on our gain if we don't invest it in a new house. What do you think we should do?
-- Laura, Overland Park, Kansas
The first thing you should do is stop worrying about being taxed on the 85 grand in profit you racked up by selling your LA digs. Prior to May, 1997, IRS rules required that you buy a new home of equal or greater value than the home you sold if you wanted to avoid paying tax on the gain.
But the new regs are a lot more lenient. Essentially, home-sale profits of up to $250,000 for single persons and as much as $500,000 for married couples are excluded from taxable income no matter what you do with those gains.
There are a few conditions you must meet to get the full exclusion -- you must have owned the home for two of the past five years and you must have lived in the home as your main residence for two of the past five years, for example -- but they're not very onerous and you can check them out by going to the IRS Web site and downloading Publication 523: Selling Your Home.
Where to put your profits
As to the issue of how much of your profit should go toward the down payment for your new hacienda, that's largely a judgment call.
By plowing all your profits into your new home, you will reduce the size of your mortgage and the monthly interest cost you must pay. In effect, you will be earning an after-tax rate of return equal to the after-tax cost of your mortgage interest expense.
So, for example, if you take out a 30-year fixed-rate home loan at 6 percent and you're in the 25 percent tax bracket, you would be locking in an after-tax 4.5 percent return in the form of interest savings.
From an investing standpoint, the question you must ask yourself is whether you think you could earn a higher after-tax rate of return than 4.5 percent by devoting less of your investing money to your mortgage and plowing as much as possible into other investments.
That will depend on what type of investments you choose and how much you keep your costs down. But I think there's a good chance that a reasonably competent investor can do better than 4.5 percent after-tax with a portfolio consisting mostly of stock funds but with a bit in bond funds for stability.
Earning that higher return is hardly a certainty, however, and you've got to evaluate whether you prefer the locked-in return from mortgage-interest savings or a shot at higher returns (with the possibility of lower ones) through investing.
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