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See addtional information: The 1997 Taxpayer Relief Act contained a big break for homeowners. If you sell your home, you may exclude up to $250,000 of your capital gain from tax. For married couples, the exclusion is $500,000. The law also removed the one time $125,000 exemption for sellers over 55 years old. The law applies to sales after May 6, 1997. To claim the whole exclusion, you must have owned and lived in your residence an aggregate of at least two of five years before the sale (this rule is called the "ownership" and "use" test). You can claim the exclusion once every two years. If You Don't Meet the Use Test Even if you haven't lived in your home a total of two years out of the last five, you are still eligible for a partial exclusion of capital gains, if you sold because of a change in employment, health or unforeseen circumstances. You get a portion of the exclusion, based on the portion of the two-year period you lived there. To calculate it, take the number of months you lived there before the sale and divide it by 24. Example, if an unmarried taxpayer lives in home for 12 months, and then sells it for a $100,000 profit, the entire amount would be excluded. Because she lived in the house half of the two-year period, she could claim half of the exclusion, or $125,000. (12/24 x $250,000 = $125,000.) That's enough to exclude her entire $100,000 gain. Nursing Home Stays For people living in a nursing home, the ownership and use test is lowered to one out of years before entering the facility. And time spent in the nursing home still counts toward ownership time and use of the residence. For example, if you lived in a house for a year, and then spent the next five in a nursing home before selling the home, the full $250,000 exclusion would be available. Husband & Wife Married couples filing jointly may exclude up to $500,000 in gain, provided: either spouse owned the residence; both spouses meet the use test; and neither spouse has sold a residence within the last two years. If a married couple each marriage and one spouse sold a residence within two years before the marriage, the other spouse may exclude up to $250,000 in gain on a residence owned before the marriage. A new marriage may also double the tax break, in some circumstances. Suppose a single man sold his principal residence on October 1, 1997, for a $500,000 profit. He and his girlfriend have been living in the house for two years, so they both satisfy the use test. If they get married by midnight December 31, 1997, they can file a joint return for 1997 and exclude the entire $500,000 of profit. Divorced taxpayers may tack on the ownership and use of their residence by their former spouse. For example, say that upon divorce, the wife is allowed to live in the husband's residence until she sells it. He has owned the residence for 18 months. Once the sale occurs, the couple will split the profits 50-50. If the wife sells the home nine months later, she may tack on her ex-husband's ownership to meet the two-year ownership test. Also, the husband may tack on his ex-wife's continued use of the residence to meet the two-year use test. Each one is entitled to exclude $250,000 of profits from the sale. Widowed taxpayers may also tack on the ownership and use by their deceased spouse. Home Offices: A Tax Drawback (being changed…see below) The exclusion does not apply to depreciation allowable on residences after May 6, 1997. If you are in a high tax bracket and plan to live in your home a long time, taking depreciation deductions for a home office is quite valuable right now. But if not, you might want to reconsider using a portion of your home as an office, because all depreciation deductions you take will be taxed at 25% when you sell the house. Example: A married couple sells a home with an adjusted basis (purchase price plus capital improvements) of $100,000 for $600,000. Over the years, they had taken $50,000 in depreciation deductions for a home office. Taxable gain: Sales Price: -$600,000 Adjusted Basis -$100,000 Taxable gain = $500,000 Of that gain, $450,000 is tax-free under the new law; the $50,000 taken as depreciation deductions is subject to 25% capital gains tax. Splitting Up Big Gains If you expect huge gains from selling a house--more than can be excluded from tax under the new rule--you should consider ways to divide ownership of the house. For example, say a couple owns their residence together with their adult son (perhaps because they have given him a share). If he meets the ownership and use tests as to one-third of the property, the son may sell his share for $250,000 gain without incurring a tax. His parents could simultaneously sell their share for $500,000 without tax, sheltering the entire $750,000 gain. This article is for information only. Check with your tax advisor for how this applies to your situation. Sale of Principal Residence Rule Changes: WASHINGTON, Dec. 24, 2002 - The Internal Revenue Service Monday issued guidance in the form of both final and temporary regulations related to excluding gain on the sale of a principal residence. Section 121 of the Internal Revenue Code allows exclusion up to $250,000 of the capital gain on a principal residence for single taxpayers and $500,000 for a married couple filing jointly. To qualify, the taxpayer must own and use the home as a principal residence for any 2 of the 5 years prior to the sale. The ownership and use periods do not need to be concurrent. The two years may consist of 24 full months or any 730 days in a 5 year period. Treasury Decision 9030 clarifies a number of issues including exceptions to the two-year rules for use, ownership and claimed exclusion "safe harbors" when the primary reason for the sale is health, change in place of employment, or "unforeseen circumstances." Short absences, such as for a summer vacation, count as periods of use, but longer breaks, such as a one-year sabbatical, do not. The taxpayer also must not have excluded gain on another home sold during the two years before the current sale. For joint owners who are not married, up to $250,000 of gain is tax-free for each qualifying owner. Employment: Exception is permitted if the new job site is at least 50 miles farther from the old home than the old workplace was from that home. This is the same distance rule that applies for the moving expense deduction. Health: Exception is permitted if the primary reason is related to a disease, illness or injury or if a physician recommends a change in residence for health reasons. In addition, a qualified person for health reasons includes close relatives, so that sales related to caring for sick family members will qualify. Unforeseen Circumstances: Exceptions occurring primarily because of "unforeseen circumstances" include:
Any of the first five situations listed above must involve the taxpayer, spouse, co-owner, or a member of the taxpayer’s household to qualify. The Regulations also give the IRS Commissioner the discretion to determine other circumstances as "unforeseen." The Regulations list several factors relevant in the determination of which home is the "principal residence" of taxpayers who own more than one home. Among these factors include:
Taxpayers do not need to allocate the gain between the business and residential use, if the business use occurred within the same dwelling unit as the residential use. Capital gains taxes must be paid on the total depreciation they took after May 6, 1997, but may exclude additional gain on the residence, up to the maximum amount. If the business use property was separate from the dwelling unit, they would allocate the gain and be able to exclude only the gain on the residential unit. The principal residence home sale exclusion may include capital gains from the sale of vacant land that has been used as part of the residence, if the land sale occurs within two years before or after the sale of the residence. For qualifying sellers, the maximum exclusion amount of $250,000 ($500,000 for a married couple filing jointly) is limited to the percentage of the two years that the person fulfilled the requirements. Thus, a qualifying seller who owns and occupies a home for one year (half of two years) – and who has not excluded gain on another home in that time – may exclude half the regular maximum amount, or up to $125,000 of gain ($250,000 for most joint returns). The proportion may be figured in days or months. A taxpayer who now qualifies for the reduced maximum exclusion and has already reported a gain from the sale of a residence on a prior year's tax return may use Form 1040X to file an amended return claiming the exclusion. Taxpayers may generally amend returns til three years from the original due date. The law did not require taxpayers to meet one of the exceptions before using the reduced maximum exclusion for homes owned on August 5, 1997, and sold within two years after that date. Thus, nearly all taxpayers qualifying under these regulations, should be able to use them by amending a recent year's return. Treasury Decision 9030, the final home sale regulations, and the T.D. 9031 are published in the Federal Register available at www.federalregister.gov or go to www.irs.gov . Every taxpayer should review their specific transaction with their own tax and/or legal advisors. This information is not intended to replace qualified tax or legal counsel. What does qualify as unforeseen, according to the new rules, are events "that the taxpayer could not reasonably have anticipated" at the time of purchasing the house. Here are some examples: The "involuntary conversion" of your home; for instance, when the state government requires you to sell your house to make way for a new highway. Natural or man-made disasters or acts of war or terror that damage the residence. The death of the homeowner, a spouse, co-owner or other person whose principal place of residence is the house that was sold. A loss of employment triggering eligibility for unemployment compensation. A change in employment status that results in the owner's inability to pay housing costs and reasonable basic living expenses for the household. Divorce or legal separation. Multiple births resulting from the same pregnancy. That pretty much completes the IRS' qualifying list of "unforeseen" precipitating events for a home sale. However, the final rules do allow taxpayers to make their case on a "facts and circumstances" basis. Good luck. On claims of health reasons precipitating early sales, the rules require that the "primary reason" for the sale must be "to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury" of the homeowner, co-owner, spouse or other domiciled resident. But if you sell early just because you think you might feel better living somewhere else, the IRS is not likely to be sympathetic: A "sale . . . that is merely beneficial to the general health or well-being of an individual" won't qualify for the tax break, says the tax agency. The final rules also incorporate important changes to the home sale capital gains law mandated by the Military Family Tax Relief Act of 2003. Members of the armed forces or the Foreign Service who are posted abroad for extended periods now will be permitted to stop the two-out-of-five-year clock when they leave the country. That, in turn, should help avoid situations where military and Foreign Service personnel confront big tax bills on home sales because they weren't occupants for long enough periods during the preceding five years. |
