Partial Exclusion of Capital Gains on the Sale of a Principal Residence

Over the past 50 years or so, the Congress has acted several times to allow homeowners to defer or even escape tax on the capital gains that result from the sale of their principal residence. The Revenue Act of 1951 was the first instance; it allowed homeowners to roll over--and thus further defer--their gains if they bought another residence of equal or greater value. The provision substantially reduced the lock-in effect for residential real estate and allowed millions of homeowners to move up to more expensive accommodations without paying any tax on gains. The provision was not, however, favorable to people who were seeking less expensive accommodations; they still had to pay tax on a portion of their gains. Most of the homeowners who did not benefit from the rollover provision were retirees, who had accrued significant gains but were scaling down on their housing because they no longer needed such large houses.

In 1964, the Congress enacted a provision allowing elderly people to exclude from tax a portion of the gains they realized from selling their principal residence. Eventually, that provision evolved into a one-time exclusion of $125,000 for taxpayers ages 55 and above. The provision permitted many retirees to sell their houses, move to smaller accommodations, and apply what they saved in taxes to their living expenses. Thus, it functioned something like a Roth IRA, except that the only permitted investment was residential real estate. The $125,000 exclusion was not indexed for inflation, however, nor was it adjusted for marital status. That meant that it lost value over time and imposed a severe penalty on elderly homeowners who either married prior to using their exclusion or married someone who had already used it.

The Taxpayer Relief Act of 1997 replaced the $125,000 exclusion with a much more liberal one of $250,000, that is available to all taxpayers, regardless of age. Moreover, this more recent exclusion is doubled for married taxpayers who file jointly, and homeowners can use it, if certain conditions are met, once every two years instead of once in a lifetime. As a vehicle for retirement saving, the new exclusion is a double-edged sword. On the one hand, it allows sellers of a primary residence to realize and consume tax savings at a much younger age than they would have been able to in the past, potentially discouraging saving for retirement. On the other hand, it allows sellers to redirect their savings to other tax-favored vehicles or even to taxable assets other than real estate that may yield a higher rate of return.