Why Are Taxes So Complicated?
There's a real estate rule referred to as "Section 121" by tax professionals, and sometimes referred to as the "main home gain exclusion" as well. The rule started off pretty simple:
A home seller is allowed to exclude the first $250,000 in gain on the sale of their home ($500,000 for married couples filing jointly) if on the 5 year window ending on the date of sale, the seller:
Lived in the home as their main home for at least 2 years
Owned the home for at least 2 years, and
Did not use this gain exclusion on the sale of any other home within the last 2 years
Simple, right? It didn't remain this way for long. Some lawmakers started to ask legitimate questions about how this rule would be handled in difficult or unusual situations. What if someone had to sell in less than 2 years because they had a job transfer to a new location? What if they had to sell in less than 2 years to move closer to a hospital that provided treatment for an illness of the taxpayer or their family members? So in the interest of fairness, lawmakers started to introduced exceptions to the rules referred to as a "reduced maximum gain exclusion". Taxpayers could get a pro-rated gain exclusion if they met certain criteria and had a valid reason (in the eyes of lawmakers and the IRS) for selling before he/she made the 2 year occupancy.
What was the effect of this rule? While it introduced some additional level of "fairness" that wasn't codified before, it also made things incredibly complicated. For example, if your job transfer was a mile away from your old job location, should you be given the same prorated gain exclusion if you sell your home in 1 year? The purpose of the reduced maximum gain exclusion was to accommodate people who really needed to sell their home before the 2 year requirement. Did the person in this predicament really need to sell their home?
Section 121 is just one example of a simple rule that has allowed for exceptions in the name of fairness. But those exceptions are what make the rule so complicated. Tax professionals like myself have taken the time to learn the rules, but even among those of us who practice in this area, there are still disagreements on the interpretations. Maybe the key to tax simplification are less exceptions?