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Taxpayer Relief Act of 1997

On August 5, 1997, the Taxpayer Relief Act of 1997

enacted into law. The laws offer Americans new tax-advantaged opportunities to reduce capital gains taxes, save for retirement and pay for education expenses. The following highlights the capital gains rulings for the sale of a primary residence and the new Roth IRA.

Exclusion of Gain on Personal Residence

Individuals are permitted in certain cases to exclude from taxable income up to $250,000 of gain ($500,000, in general, for married couples filing a joint return) realized on the sale or exchange of property that has been used as a principal residence. The exclusion does not apply to any gain attributable to depreciation deductions taken in connection with the rental or business use of the property for periods after May 6, 1997.

To qualify, the taxpayer must have owned and used the property as his or her principal residence for at least two years during the five-year period ending on the date of the sale or exchange. The exclusion is allowed each time a taxpayer who sells or exchanges a principal residence meets the eligibility requirements, but generally no more often than once every two years. A taxpayer is entitled to a pro rated amount of the exclusion if he or she fails to meet either of the two-year requirements by reason of a change in place of employment, health, or other unforeseen circumstances. In such case, the amount of the exclusion the taxpayer is entitled to is a ratio of the amount that would have been allowed if the two-year requirements had been met. The ratio is the aggregate amount of time he or she owned and used the property as his or her principal residence during the five-year period, or, if shorter, the amount of time since the most recent prior sale to which the exclusion applied, to two years (the pro ration rule).

The new law repeals the "rollover" rules that have allowed taxpayers to defer the gain on a sale or exchange of a principal residence to the extent that the proceeds of the sale are applied to a replacement residence within two years. It also repeals the once-in-a-lifetime $125,000 exclusion on a sale of a principal residence for taxpayers age 55 and over.

Example: Mr. and Mrs. Jones purchased and occupied a principal residence in Burlington in 1998. Exactly one year later, Mrs. Jones is transferred by her employer to Binghamton and the Jones family moves. They sell their home for a $200,000 gain. Because the time the Jones family spent in the residence is only one-half of the required two years, the amount of gain they would be eligible to exclude is limited to one-half of the amount otherwise allowed, or $100,000.

The $500,000 exclusion applies to married couples filing a joint return where either spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse has had a sale in the preceding two years subject to this exclusion. Married couples filing a joint return who do not share a principal residence are each entitled to an exclusion of $250,000. A single taxpayer who marries a taxpayer who has used the exclusion within two years prior to the marriage would also be allowed a $250,000 exclusion. Once both spouses satisfy the eligibility requirements and two years have passed since the last exclusion was allowed to either spouse, a full $500,000 exclusion would be available for the next sale or exchange of their principal residence.

Many other special rules apply, including:

* A taxpayer can elect not to have the exclusion apply to any sale or exchange.

* Certain periods an individual resides in a nursing home on account of physical or mental incapacity are included as part of the two-year use requirement if certain other rules are met.

* An individual whose spouse is deceased on the date of the sale of the property can include the period the deceased spouse owned and used the property before death.

* An individual is treated as using property as his or her principal residence during any period of ownership while the individual's spouse or former spouse is granted use of the property under a divorce or separation instrument.

* In the case of stock held as a tenant-stockholder in a cooperative housing corporation, the ownership requirement applies to the holding of such stock and the use requirement is applied to the house or apartment the taxpayer is entitled to occupy as a stockholder.

The new exclusion is effective for sales or exchanges after May 6, 1997. However, a taxpayer may elect to be subject to the old rule (i.e. , the rollover and $125,000 exclusion provisions) if:

* the sale or exchange occurred prior to August 5, 1997;

* the sale or exchange occurs after August 5, 1997, but is pursuant to a binding contract in effect on that date; or

* no gain on the sale would be recognized, under the prior-law rollover rules, on account of a replacement residence that was acquired on or before August 5, 1997 (or pursuant to a binding contract in effect on that date).

Where a taxpayer acquired his or her residence in a transaction covered by the prior rollover rules, the periods of ownership and use of the prior residence are taken into account in determining ownership and use of the current residence.

Taxpayers who own property on August 5, 1997, and sell the property before August 5, 1999, but who fail to meet the ownership and use requirements to otherwise qualify for an exclusion, can use the pro ration rule to qualify for a pro rated exclusion based on the period they did own and use the property.

Taxpayers who have gain on the sale of their principal residence in excess of the $250,000/ $500,000 limits of the new exclusion and who meet one of the tests of the transition rule to elect not to apply the new rules should consider taking advantage of the old law's rollover provision if they are replacing their old principal residence with a new one, as long as the cost of the new residence is more than the allowable exclusion under the new law.

For example, Mr. and Mrs. Smith sell their house, which they purchase 40 years ago for $500,000, for a sales price of $6 million, after May 6, 1997, but prior to August 5, 1997. Under the new law, the Smiths would be taxed on $5 million of gain ($6 million less $500,000 basis less $500,000 exclusion). Assuming the Smiths replaced their residence with a new one costing more than $1 million, they would be better off electing to be taxed under the old rules.

Savings Incentives

Roth IRAs

The Roth IRA, a new savings vehicle, presents a unique opportunity for a taxpayer to receive tax-free income. The general features of the Roth IRA are:

* No deduction up front. Contributions are limited to $2,000 per year (presumably a Roth IRA can be set up for each spouse) and can be made even after age 70-1/2. The $2,000 limit is reduced for taxpayers with AGI above $150,000 ($95,000 if single) and eliminated if AGI is above $160,000 ($110,000 for singles). The regular IRA rules will apply except where expressly changed. The $2,000 limit is reduced for amounts contributed to a regular IRA.

* Qualified distributions come out tax free , rather than tax deferred (i.e. , the taxpayer has basis in the original contributions and pays no tax on any gains)

* Qualified distributions are those made from earnings in the account:

o after age 59-1/2

o on death or disability;

o in a qualified first-time homebuyer distribution, subject to a $10,000 lifetime limit. The distribution must be used to acquire a principal residence of the taxpayer, a spouse child, grandchild, or ancestor. A first-time homebuyer, generally, is a taxpayer who has not owned a principal residence for two years. No qualified distributions can be made until the taxpayer has had a Roth IRA for five years.

* The regular IRA required minimum distribution rules during lif do not apply (i.e.), distributions need not start at age 70- 1/2). On death, the account must be emptied within five years, or an annuity must be purchased within one year of death, or distributions must continue to the beneficiary "at least as rapidly" as before death.

Conversion : The new Roth IRA goes into effect for tax years beginning after 1997. A regular IRA owned by a taxpayer with AGI of no more tha $100,000 (who is not married filing separately) can be converted into a Roth IRA before the end of 1998. The taxpayer would take converted IRA amounts into income, and pay any tax on the distribution ratably over four years. The 10 percent early distributions tax would not apply to the conversion.

Paying the tax on an existing IRA and converting it into a Roth IRA could provide unlimited tax-free build-up until death. Roth IRAs could make contributions to some employer plans less attractive because amounts contributed to and earned in employer plans are only tax deferred, while amounts earned in the Roth IRAs are tax free. Roth IRA trustees may have a difficult time keeping track of the income tax reporting for four years under their current systems since those systems are tied to actual distributions/contributions. The Roth IRA contribution comes in one year, but reports on those contributions will be needed for four years.

Deductible IRAs

Two important changes will make more individuals eligible for a deductible IRA. Beginning in 1998, the deductibility of an individual's IRA contribution will not be affected by whether the individual's spouse is an active participant in an employer's retirement plan, unless the couple have an AGI above $150,000. If they have an AGI above $160,000, there is no deduction for the spouse of an active participant.

Under prior law, the deduction is phased out as the income level rises over the next $10,000. Under the new law, the deduction phases out over $20,000 for joint returns for years beginning after 2006.

Penalty-Free Withdrawals for Education and First-Time Homebuyers

The 10 percent penalty that applies to most withdrawals from IRAs before the account owner reaches age 59 1/2 will not apply to withdrawals for higher education expenses of the taxpayer, spouse, children, or grandchildren . This change applies to distributions after 1997 for expenses paid for academic periods after 1997. The new law also permits a penalty-free qualified first- time homebuyer distribution, subject to a $10,000 lifetime limit. The distribution must be used to acquire a principal residence of the taxpayer, a spouse, child, grandchild, or ancestor. This distribution is available, generally, if the taxpayer has not owned a principal residence in the preceding two years.