01/26/10: Home Selling Exclusions: A Great Benefit for Homeowners
By Benny L. Kass
The more you earn, the less you keep, And now I lay me down to sleep. I pray the Lord my soul to take, if the tax collector hasn't got it before I wake.
You sold your house last year. It was not the best of time based on market conditions. Many home sellers made little or no profit and some even sold at a loss. But for homeowners who bought their home years ago, and benefited from the huge gains during the first part of this century, they may be pleasantly surprised. If you are married, and if you meet the legal requirements described below, you can exclude up to $500,000 of the profit you have made. If you are not married, or file a separate tax return, the exclusion is reduced down to $250,000 of profit. In simple terms, this means that you will not have to pay any tax on that portion of the excluded profit you have made.
For many years, there were two tax concepts which helped save homeowners from paying a lot of capital gains tax: the "roll-over" and the "once in a lifetime". However, the Taxpayer Relief Act of 1997, signed by President Clinton on August 5, 1997, abolished both of these concepts. The roll-over and the once-in-a-lifetime exemption for homeowners over 55 years of age, are real estate and tax history.
Although there are no restrictions on the number of times this exclusion can be used (as compared to the old "once-in-a-lifetime" approach) the law does contain two important conditions:
1. You must have owned and used the home as your principal residence for two out of five years before the house is sold. This is known as the "ownership and use" test. If you are married, in order to claim the gain , both husband and wife must meet the use test, but either spouse has to meet the ownership test. If you cannot qualify jointly, if one spouse can meet both tests, he/she can still claim the up-to-$250,000 gain exclusion.
In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirements will include any time that the former spouse actually owned the property before the transfer to the other spouse.
If your spouse died before the house is sold, your use and ownership includes any time in which your spouse owned and used it. So if you meet the two tests, if you sell the house within two years from the date of death, and you have not remarried at the time of the sale, you are still able to take the full $500,000 exclusion.
2. The exclusion is generally applicable once every two years. However, if you are unable to meet the two year ownership and use requirements because of a change in employment, health reasons or unforeseen circumstances (which have been defined by regulations promulgated by the IRS), then your exclusion is pro-rated. These pro-rations are complex, and have caused considerable confusion among lawyers, taxpayers and even the IRS.
The IRS regulations provide "safe harbors" -- i.e. if you fall into a safe harbor category, you are entitled to take the partial exclusion. If, on the other hand, you are not within the safe harbor, then according to the Regulations "the taxpayer may be eligible to claim a reduced maximum exclusion if the taxpayer establishes, based on the facts and circumstances, that the taxpayer's primary reason for the sale... is a change in place of employment, health or unforeseen circumstances."
In other words, if you are not within a safe harbor, you will have to convince the IRS that you nevertheless qualify for the partial exemption.
Let's look at these items separately:
1. Change in employment: if you have to travel at least 50 miles father from the house you sold because of a job transfer, or even to take a new job, and the primary purpose of selling your house was because of employment reasons, you will be eligible for the partial exclusion.
The 50 mile distance is the IRS "safe harbor", provided that the change in place of employment occurred during the time that the taxpayer owned and used the home. However, even if you cannot meet the safe harbor, you still may be able to convince the IRS to allow the partial exemption based on ""facts and circumstances"" The Regulations include an example of a doctor who sold her condominium and moved only 46 miles away from the previous residence. Because the primary reason for the sale was to allow the doctor quicker access to the hospital for emergency purposes, the IRS would allow the partial exemption based on the facts of this case.
2. Reasons of Health: Once again, we see the concept of "primary purpose". To qualify for the partial exemption, the primary purpose of selling the house must be based on health.
The safe harbor here is easy: if the taxpayer's physician recommends a change of residence for reasons of health, the taxpayer will automatically qualify for the partial exclusion. And health is rather broadly defined to include "the diagnosis, cure, mitigation or treatment of disease, illness or injury".
But the IRS issues a precautionary note: a sale "that is merely beneficial to the general health or well-being of an individual is not a sale .. by reason of health."
3. Unforeseen circumstances: Obviously, this is the more difficult category on which to enact regulations. Each of us -- at one point in time -- will face conditions which could not be anticipated or even imagined before it happened, which significantly impact on our lives -- and on our financial situation.
Nevertheless, it would be manifestly unfair to be faced with a crisis -- have to sell your house before the two years are up -- and have to pay full tax on the profit you have made. Accordingly, Congress authorized the IRS to issue regulations governing this area.
The IRS regulations list several safe harbors:
- involuntary conversion of the residence -- for example, it was condemned by a governmental agency;
- natural or man-made disasters or acts or war or terrorism resulting in a casualty to the residence. Clearly, the victims of a hurricane or a mudslide who lost their house would fall squarely in this category;
- death of one of the owners of the property;
- the cessation of employment as a result of which the taxpayer is eligible for unemployment compensation;
- a change in employment or self-employment status that results in the taxpayer's inability to pay housing costs and reasonable basic living expenses;
- divorce or legal separation under a Court decree, or
- multiple births resulting from the same pregnancy.
These are safe harbors. If you fall within one of these areas -- and have owned and used your house since it was purchased-- you will be entitled to take the partial exclusion of gain.
But, once again, even if you cannot claim a safe harbor, you still may be able to convince the IRS that there are facts and circumstances which forced you to sell your house before the two years were up. The burden will be on you, and as we all know, dealing with the IRS is not easy.
If you are eligible for the partial exclusion, it is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is 2 full years. If you are single -- or do not file a joint tax return -- change the $500,000 to $250,000.
The law applies to all principal residences: single family homes, cooperative apartments, and condominium units. If your boat or your mobile home is your principal residence, and you meet the use and ownership tests, you can claim the exclusion. In order to qualify as such, three things are required: sleeping quarters, a toilet, and cooking facilities.
As with everything dealing with taxes, talk with your financial and legal advisors before you list your property. You can also find good material on the IRS website (irs.gov) and look for Publication 523, entitled "Selling your Home".
It is absolutely critical that you keep all of your records and all of your settlement sheets. Such expenses as home improvements, real estate commissions, legal and title costs, will reduce your profit -- and thus reduce your tax. If you are ever audited by the IRS, you will be required to produce proof of these expenses.