CRS ISSUES REPORT ON EXCLUSION OF GAIN FROM SALE OF HOME.

Louis Alan Talley Research Analyst in Taxation Economics Division

April 5, 1990 Updated January 16, 1992

SUMMARY

A taxpayer may elect to exclude from gross income up to $125,000 of gain from the sale of a residence, provided (1) the taxpayer was at least 55 years of age before the date of the sale or exchange and (2) he owned and occupied the property as his principal residence at least three years within the five-year period before the sale. A special exception is provided those taxpayers who become physically or mentally incapable of self-care.

The Revenue Act of 1964 instituted the exclusion of the first $20,000 of the sales price. Congressional concern was that elderly taxpayers whose families had grown may no longer need the family home and desire to purchase a less expensive home or move into an apartment. Thus, they may require some or all of the proceeds from the sale to meet living expenses during retirement. The Tax Reform Act of 1976 increased the amount of the exclusion to $35,000. It was raised because the sales price of homes had more than doubled. With the passage of the Revenue Act of 1978 the exclusion amount was raised to $100,000 and the age limit was lowered from 65 to 55. This change was made as Congress felt that many were retiring at an earlier age and that increasing housing costs had made the dollar amount unrealistic. Again, under the Economic Recovery Tax Act of 1981, an increase to $125,000 was provided because of increased housing costs. Finally, the change in the residency requirement for those who must stay in a nursing home was effected in the passage of the Technical and Miscellaneous Revenue Act of 1988.

A number of changes have been proposed in the current Congress. Among those proposals are that the age requirement be eliminated. Another proposal would eliminate the age requirement only if the taxpayer or a family member becomes physically or mentally incapable of self-care. Other proposals repeal the taxation of any gain from the sale of a principal residence. Another provides that the one-time exclusion of gain shall not be precluded because the taxpayer's spouse elected the exclusion before marrying the taxpayer.

Proponents have argued that purchase of a home is not typically made for investment purposes and as such is not a proper subject for taxation. Profits from sale of the home often arise from inflation and uncapitalized costs. Thus, it is noted that current law provides disincentives to mobility and choice in housing except in the case of age and reinvestment.

Objections to further liberalizations of the current law include lost revenue and difficulty in tax administration. Some taxpayers believe that homeowners already receive excessive tax benefits from such provisions as tax deductions for interest expense and property taxes, the tax exemption for imputed rental value, and deferral of taxation when proceeds are reinvested in another home. Finally, the Federal tax system is based on ability-to-pay and gains from home sales reflect ability-to-pay as much as other income.

CONTENTS

LEGISLATIVE HISTORY

LEGISLATIVE PROPOSALS FOR CHANGE

ARGUMENTS FOR AND AGAINST LEGISLATION

INCOME TAX EXCLUSION OF GAIN FROM SALE OF A PRIMARY RESIDENCE

This report provides information on legislative proposals to change the $125,000 income tax exclusion of gain from the sale of a primary residence of taxpayers over the age of 55. After an initial discussion of current law, a legislative history is provided as well as basic information on current legislative proposals, and the primary pros and cons of suggested changes.

Under present law, the gain from the sale of a taxpayer's principal residence is taxable, but the tax may be deferred. If another residence is purchased or built within the prescribed time period, the taxpayer may qualify for the nonrecognition of all or part of the gain on the sale of the old residence, thus deferring tax on the nonrecognized gain. However, the basis of the new residence is reduced by the amount of the nonrecognized gain. ¹ This provision is available to all taxpayers.

A taxpayer may also elect to exclude from gross income up to $125,000 of gain from the sale of a residence, provided (1) the taxpayer was at least 55 years of age before the date of the sale or exchange, and (2) he owned and occupied the property as his principal residence for a period to taking at least three years within the five-year period ending on the date of the sale.

Short periods of absence, such as for vacations, even if rented during those periods, are counted towards the three-year required period. A special exception to the occupancy rule is provided in the Technical and Miscellaneous Revenue Act of 1988 (Public Law 100-647). Added under a Senate amendment was a provision that allows a taxpayer who becomes physically or mentally incapable of self-care and who owns and uses a residence for at least one year and then enters a State-licensed facility, the use of this exclusion.

Taxpayers meeting these two requirements can elect to exclude from gross income the entire capital gain from the sale or exchange if the capital gain is less than $125,000 or the first $125,000 of profit if the gain is greater. The election may be made only once in a lifetime. If either spouse has previously made an election (individually, jointly, or from a previous marriage), then neither is eligible to elect the exclusion.

LEGISLATIVE HISTORY

The Revenue Act of 1964 (P.L. 88-272) provided the first exclusion from taxation for capital gains on the sale of a primary residence by the elderly. The exclusion applied to residences disposed of after December 31, 1963.

In its report, the Rouse Committee on Ways and Means stated that the then-current law which permitted the postponement of the taxation of the gain on the sale of a residence, if another residence was purchased within a year, was adequate for younger taxpayers. However, it was not adequate for the elderly taxpayer whose children had grown and who no longer needed the family home. The report states:

* * * * Such an individual may desire to purchase a less expensive home or move to an apartment or to a rental property at another location. He may also require some or all of the funds obtained from the sale of the old residence to meet his and his wife's living expenses. Nevertheless, under present law, such an individual must tie up all of his investment from the old residence in a new residence, if he is to avoid taxation on any of the gain which may be involved.

Your committee concluded that this is an undesirable burden on our elderly taxpayers. ²

The Committee was primarily concerned with the average and smaller home selling for $20,000 or less. Therefore, it limited the application of the provision so that a full exclusion of gain would be attributable only to the first $20,000 of the sales price. Above that level, a ratio was to be used to determine the gain subject to taxation. This ratio was such that the lower the adjusted sales price, the greater the benefits derived from the exclusion. To prevent elderly taxpayers from obtaining numerous exclusions for gains on personal residences, the Committee provided that this exclusion would be available to a taxpayer and his spouse only once in their lifetimes. "Elderly" then meant aged 65 or older.

The Tax Reform Act of 1976 (P.L. 94-455) increased the amount of the exclusion to $35,000. The reason given for this change was that the sales prices of homes had more than doubled since the adoption of the provision in 1964. ³

With the passage of the Revenue Act of 1978 (P.L. 95-600), the exclusion was further liberalized. This time, the exclusion amount was raised to $100,000 for sales or exchanges after July 26, 1978, and the age limit was lowered to 55. Additionally, the exclusion would not be subject to the ratio requirement of prior law if the adjusted sale price for the home exceeded the exclusion amount. The reason for change was given as follows:

The Congress believed that the taxes imposed upon an individual with respect to gain that he or she realizes on the sale or exchange of his or her principal residence, in many instances, may be unduly high, especially in view of recent inflation levels and the increasing cost of housing. . . . the Congress believed that the prior dollar limits and age restriction were unrealistic in view of increasing housing costs and decreasing retirement ages. ⁴

Giving once again the increased cost of housing as a rationale, the Congress under the Economic Recovery Tax Act of 1981 (P.L. 97-34) provided an increase in the exclusion amount from $100,000 to $125,000.

Finally, the change in the residency requirement for those who must stay in a nursing home was effected in the passage of the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647). The rational for this change is not explicitly given in the Rouse or Senate Reports. However, the Congress apparently believed that an involuntary breach of the occupancy rule due to illness should not cause the loss of a tax benefit.

LEGISLATIVE PROPOSALS FOR CHANGE

A number of suggested changes to this Internal Revenue Code provision have been proposed in recent years. Detailed are proposals from the current Congress.

First, it has been proposed that the age requirement be eliminated entirely. This proposal reflects the increasing number of early retirements. Some occupations, such as police, firefighter, and the military, have retirement ages below age 55. In the current Congress, a specific bill with this provision is R.R. 106 introduced by Representative Gilman.

A second proposal would eliminate the age requirement only if the taxpayer becomes permanently and totally disabled. This proposal was introduced as H.R. 1076 by Representative Pickett. A similar proposal has been introduced by Senator Helms in S. 1202 which provides that the one-time exclusion may be taken if the taxpayer or a parent, spouse, or child of the taxpayer is physically or mentally incapable of self-care for a period of at least six months.

Other legislative proposals have been made which would repeal the taxation of any gain on the sale of a principal residence if the residence was owned and used by the taxpayer for at least three out of five years. Representative Schulze's proposal (R.R. 1287) retains the one-time use while another proposal, embodied in R.R. 368 and introduced by Representative McEwen, allows multiple tax-free gains. While no legislation has been introduced in the current Congress, there has been a proposal in previous sessions of Congress to raise the $125,000 exclusion by an automatic inflationary escalator.

Another proposal provides that the one-time exclusion of gain from sale of a principal residence shall not be precluded because the taxpayer's spouse, before becoming married to the taxpayer, elected the exclusion. Such a proposal has been introduced by Senator Helms in S. 1203.

A proposal introduced in both the Rouse and Senate provides that the one-time exclusion is available to those taxpayers who use a home equity conversion sale-leaseback transaction in order to purchase long-term health care insurance. This proposal has been introduced in the Rouse as H.R. 2446 by Representative Ritter and in the Senate as S. 1122 by Senator Specter.

Representative Jenkins has introduced R.R. 3363 which provides for individual investment accounts. Included among this bills provisions are both the nonrecognition of gain on the sale of a principal residence when an amount, equal to the taxable gain, is deposited into the account and a provision that when amounts from the current $125,000 exclusion are contributed, they retain their tax- free status when withdrawn from the individual investment account.

Finally, R.R. 3465 introduced by Representative William Thomas expands the one-time exclusion of gain based on the amount of increase in equity in the new residence. This bill provides that if the new principal residence costs less than the previous residence the gain is excluded if the gain is rolled over as equity into the new residence.

ARGUMENTS FOR AND AGAINST LEGISLATION

B. Kenneth Sanden of Price Waterhouse Co. of New York has argued that the age requirement should be eliminated. He states:

The investment in a residence is a non-business personal matter and not a transaction entered into for a profit or risk. Accordingly, it appears doubtful that it is a proper subject for income taxation. Generally residential profits are the result of very long-term investment and arise largely because of the inflationary reduction in the value of the dollar. To some extent they may also represent uncapitalized costs incurred over a period which enhance the ultimate value. Recognition of these factors has resulted in attempts to alleviate the tax inequities by providing complicated procedures and DISCRIMINATORY limitations for sales by the elderly or where the proceeds are reinvested in another residence. Early retirement is becoming more common and illness may also provide the impetus to dispose of a larger residence. Age and reinvestment should not impose a tax barrier to mobility and choice of housing.

If a sliding scale for taxing capital gains is adopted there would, of course, be additional relief in the tax treatment of sales of personal residences. This coupled with the present provisions, however, might create such complexities so that the victory might not be worth the fight, and accordingly, it is recommended that gains on a personal residence not be recognized in any amount for federal income tax purposes. ⁵

The proposal to extend this exclusion to persons who become handicapped or disabled could be defended as encouraging the use of private assets to pay for health or custodial care expenses that might otherwise become public costs. Also, it could be argued that retirement due to disability is not different from retirement due to age, and that the same arguments that persuaded the Congress to grant this tax benefit to over-55 retirees also apply to disabled retirees.

However, one might expect several objections to be raised against the proposals. The Treasury Department could be expected to object on the basis that they would result in a revenue loss. Removing the age limit entirely could increase the revenue loss considerably. Liberalizing this provision could place additional enforcement burdens on the Internal Revenue Service, such as determining whether someone is really handicapped and/or monitoring lifetime home sales by younger people.

An objection could be raised by those who believe that homeowners already receive excessive benefits from special treatment under U.S. income tax laws. Besides the deferral and exclusion of gain on the sale of a home, there are income tax deductions for interest expense and property taxes and tax exemption for imputed rental value, all providing significant benefits for homeowners and not available to those taxpayers that rent.

Finally, objections could be raised that the Federal income tax system is based on ability-to-pay; thus, income from the sale of capital assets should be treated no differently than income earned from other endeavors. Gains from the sale of a home are income and should be taxed accordingly. As such, taxpayers affluent enough to own a home receive benefits from this exclusion while those who rent receive no tax benefits.

² U.S. Congress. House. Committee on Ways and Means. House Report No. 749. 88th Congress, 1st session. Sept. 13, 1963, p. 45.

³ Congressional Record, August 6, 1976, v. 122, p. S13749 (Daily Edition). In remarks of Senator Mark Hatfield who offered the amendment to increase the exclusion.

⁴ U.S. Congress. Joint Committee on Taxation. General Explanation of the Revenue Act of 1978 (H.R. 13511, 95th Congress; Public Law 95-600). Washington, U.S. Govt. Print. Off., 1979. p. 255- 256.

⁵ U.S. Congress. House. Committee on Ways and Means. Panel Discussions. General Tax Reform, Part 2 -- Capital Gains and Losses. 93rd Cong., 1st. sess., Washington, U.S. Govt. Print. Off., February 6, 1973, p. 254.