Subject: CA recent tax law change: withholding for less than 24 months in principle residence
Date: Sat, 26 Apr 2003
My wife and I purchased our present home in December of 2002 after having rented for the previous 5 months, and prior to that we owned a home that we inhabited for 3 years, which we sold. Due to changes in our personal economic situation, we have just put our current house on the market, and have decided to rent again for a while. We have lived here for 17 months, and we do not own any other property.
Our real estate agent just informed us that since we have owned our home for less than 2 years, the State of California will forcibly withhold 3.33 percent of the sales price of the home, should we show any profit. We anticipate that we will make only $2,000 after all is said and done. However, if our real estate agent is correct, this small profit will result in the State of California withholding over $30,000 of money that we need until we file our state taxes next year.
Is this correct? We have lived in our current home 17 out of the last 24 months, and it is our principle residence, but we do need to sell the house now and we cannot afford to tie up $30,000 until next year. We do not understand the capital gains implications of selling prior to 2 years of principle residency.
Thank you very much for your response.
San Ramon, CA
Date: 30 Apr 2003
First, check your figures. In order to have $30,000 withheld, your sales price would be about $900,000.
In order to avoid withholding, you need to correctly check box 2 on Form 593-C. That question is, "Does the property you are selling qualify as your principal residence within the meaning of Internal Revenue Code Section 121?"
An issue may be the sale of your previous residence. According to §121(b)(3), the exclusion can only apply if it hasn't previously been used within two years of the current sale.
If you fail either the 24-month residency requirement or the 24-months after previous sale requirements, you might still qualify for a partial exclusion under §121(c). The conditions are explained at temporary Treasury Regulations §1.121-3T. The sale or exchange is by reason of a change in employment, health, or unforeseen circumstances. For the change of employment exception to apply, the place of new employment must be at least 50 miles farther from the residence sold or exchanged than the previous place of employment. There is another specific event safe harbor under temporary regulations §1.121-3T(e)(2)(C) that could help you. If there is a change in employment or self-employment status that results in the taxpayer's inability to pay housing costs and reasonable basic living expenses for the taxpayer's household, you may qualify for the partial exclusion.
The partial exclusion is computed by making a ratio, the numerator being the shortest of the period of time the taxpayer owned the property during the 5-year period ending on the date of the sale or exchange, or the period of time between the date of a prior sale or exchange of property for which the taxpayer excluded gain under section 121 and the date of the current sale or exchange. The numerator of the fraction may be expressed in days or months. The denominator of the fraction is 730 days or 24 months. The ratio is multiplied times the maximum exclusion amount ($250,000 or $500,000 for married, filing jointly) to determine the exclusion that applies to the sale.
If the partial exclusion applies to you, ask if a letter from a CPA or attorney stating that you qualify will satisfy the escrow company processing the withholding form. Then you can answer "yes" for box 2 and avoid the withholding.
If this approach doesn't work, you have several choices to avoid the withholding. One is to simply reduce your sales price to net zero gain. Another is to take the home off the market until you meet the 24-month residency requirement. If you need some cash, you could refinance your home or get a home-equity line of credit to tide you over this period.
I hope this helps.
Everyone is unhappy about withholding being required based on the selling price of real estate, but the alternatives proposed so far haven't been acceptable to the real estate industry. The State of California is dealing with a severe budget crunch and desperately needs the money. Of course, the current rules aren't "fair" and will eventually be repealed, but we have to live with them for now.
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