Capital gains on real estate

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I started thinking about this after a recent conversation with someone…

Does the capital gain exclusion for primary residence enrich some people who game the system?
I’m thinking specifically about someone selling a house. Some states don’t tax capital gains at all, but my understanding is that most do, with an exclusion for selling your primary residence if the gains are below a certain threshold (like the federal amounts).

But states that do tax gains on a home – do people game this?
One way is if you move out of the state, or if you didn’t live there but had a property, just don’t pay it! Claim it was your primary residence, don’t file taxes, don’t claim it, and get away with it?

My state (NJ) collects a % at settlement of a house sale – a prepayment of capital gains taxes that gets settled up when the person files their income taxes (adjusting for capital improvements, etc). So if it was a primary residence and the gains are under the limits, the person gets the withheld $$ back. People call it an “exit tax” and claim they are being taxed for moving out of state!! But it’s really just a way to prevent non-payment of CG tax on gains from the sale of real estate that isn’t excluded.

An example (true) – a family lives in PA as their primary home. They own a vacation home at the Jersey Shore (for themselves, or maybe they rent it out?). They claim that they lived at the shore house for the last 2 years and that their son lives in the PA house (yet their taxes are filed as PA residents, not NJ residents). They think they should be excluded from capital gains (state, federal) on the gains of the shore home sale because they supposedly had it as their primary home. NJ said “no way” – it’s a second home / investment home, they weren’t NJ residents, not their primary home.

I’m curious what other states do to collect CG on the sale of real estate?
I think NJ probably passed this law (1980s I think) because people moved out and didn’t pay up!!

Of course, some people say that capital gains should never be taxed. But I ask “why”? Wage earners get taxed (at a higher rate). Investors don’t earn wages, but they earn income as gains, and should also be taxed. In that sense, wealthier people with investments get enriched by paying lower tax rates than wage earners.

Nobody wants to pay taxes, but if people paid up, maybe the rates would be lower for everyone!

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Based on your example it sounds correct. You cant claim your primary residence in one state and then sell a home in another state tax free using the exemption. Now, if they are smart, they would actually move into the the NJ home for 2 years, file taxes using that address, then sell it. They can then move back to their PA home and start the 2-year clock again. This seems like a lot of work to avoid whatever NJ charges for capital gains. On the federal side its much easier…they can sell the NJ property and then purchase another property somewhere else using 1031 and exempt the federal capital gains taxes.

We know a couple of real estate investors that purchase million dollar distressed properties, live in them for 2 years while renovating, then sell and keep all the gains and repeat the process. We may consider doing the same thing once our kids are out of the house.