Unless the taxpayer qualified for the over age 55 exclusion, profits from home sales prior to May of 1997 were generally deferred into the replacement home. This, in effect, reduced the tax basis of the replacement home, so that when it is sold, the profit from the previous home is taken into account when determining the overall profit from both homes. With the current law allowing a $250,000 ($500,000 for qualified couples filing jointly) exemption, many individuals forget about the deferred gain from the first home finding out after the fact that their profit is larger than expected.
For example, a single individual makes a profit of $175,000 from the sale of a home in 1994. That profit is deferred into a replacement home costing $300,000. Now the replacement home is sold for $500,000. Without considering improvements or sales costs, the overall profit from the replacement home is $375,000 (the $200,000 profit from the replacement home plus the $175,000 profit deferred from the previous home). After taking into account the $250,000 gain exclusion, the taxpayer would end up with a taxable profit of $125,000. Since there is no longer any deferral of profits, the $125,000 will be taxable.