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March 2002
Vol. 11, No. 3
pp 47–48, 51.
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Milton Zall
IRS clarifies residence sales

The Taxpayer Relief Act of 1997 is finally implemented.

opening artThe IRS has published regulations on how to exclude a gain (for tax purposes) from the sale or exchange of your principal residence. These regulations reflect changes to the law made by the Taxpayer Relief Act of 1997, as amended by subsequent legislation enacted in 1998. These regulations apply to individuals who sell or exchange their principal residences. Although the Tax payer Relief Act of 1997 was passed more than three years ago, the IRS had yet to issue definitive guidance on the provisions of this legislation.

For sales made after May 6, 1997, the new law replaces the old rules that allowed individuals who sold their home at a profit to roll over the proceeds of the sale into the purchase of another home to avoid paying any capital gains taxes. In addition, the old law permitted individuals over age 55 to claim a once-in-a-lifetime exclusion of $125,000 in capital gains resulting from the sale of their home.

Principal Residence
A house, houseboat, mobile home, cooperative apartment, or condominium can be a principal residence. To qualify for the tax exclusion, you must satisfy both the ownership and use requirements—you must own the principal residence for at least two of the five years before the sale or exchange and live in it for at least two of the five years. The two years need not be continuous. (The use requirement is met if you lived in the home the first and fourth years, for example.) Short absences from your home are ignored. For example, a two-month summer vacation is treated as time lived in your principal residence. But a one-year absence is too long. Time spent in your home by your son, daughter, or other family member doesn’t count either. If you have two or more homes, the one used the majority of time in a year is treated as your principal residence, unless you can show otherwise. You can be living elsewhere when you sell your home if the two-year test is met. If you alternate between two properties, using each as a residence for successive periods of time, the property that you use for a majority of the time during the year will ordinarily be considered your principal residence.
The new law provides a new universal exclusion that should benefit most, but not all, homeowners. Under the new law, a tax exclusion for gain of up to $250,000 is available to individuals. Married couples filing a joint return can claim a tax exclusion of as much as $500,000.

To qualify for the exclusion, you must use the property as your principal residence for a total of two years, not necessarily consecutive, out of the five years preceding the sale. Only one sale or exchange every two years is permitted, but sales prior to May 7, 1997, do not count.

All or part of the gain from the sale of a principal residence may be excluded from income if certain ownership and use tests are met. Any gain in excess of these amounts is taxed at the capital gains tax rates.

The IRS Restructuring and Reform Act of 1998 settles the question of how to apply the new capital gain exclusion to the sale of a residence owned and used for less than two years. Those homeowners can exclude an amount of the $250,000 or $500,000 capital gain exclusion equal to the fraction of the two years that the ownership and use requirement is met. For example, a taxpayer who owns and uses a principal residence for one year and then moves because of a job transfer may exclude up to $125,000 (half of the regular $250,000 exclusion). Assuming the homeowner realizes only a $75,000 gain, it is all excluded, rather than only half of the $75,000.

Only one spouse needs to own the home, but both must have lived there two years to qualify for the joint filing $500,000 exclusions. For divorced or separated spouses, if either meets the two-of-five test and one lives there by court order, each can exclude $250,000. If a residence is transferred to a taxpayer as a result of a divorce, the time during which the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership. A taxpayer who owns a residence is considered to be using it as a principal residence while the taxpayer’s spouse or former spouse is given use of the residence under the terms of a divorce or separation. There’s a break for sales due to job changes, bad health, or unforeseen circumstances, even if the two-year residency test isn’t met. The percentage of the $500,000 or $250,000 exclusion that can be claimed depends on the fractional part of the two-year period that the home was owned.

Home Office Deduction
If a portion of the principal residence is used as a home office (you have taken a home office deduction on your tax return), the exclusion does not apply to the portion of gain that’s attributable to the home office. If no home office deduction was claimed for at least two of the previous five years, you qualify for the full exclusion (provided ownership and use tests are satisfied). If the office space was not used for residential purposes for two years in the five years before the sale, the gain on the office portion is taxed.

For example, suppose a single tax payer owned and lived in the principal residence for the past five years and sold it in 1998 for a $300,000 gain. The full amount of the gain exclusion applies—$250,000 of the gain would not be subject to the federal tax. The remaining $50,000 gain is subject to the capital gains tax (20% for property held more than 12 months). After two years, the single taxpayer can exclude up to $250,000 of the gain on the sale of another residence.

For married taxpayers to qualify for the full $500,000 exclusion, both spouses must live in the home for at least two of the five years preceding the sale or exchange, and neither spouse could have used the exclusion during the previous two years.

Only one spouse, however, must meet the two-year ownership test. If only one spouse meets both the ownership and use requirements, the $250,000 exclusion for a single taxpayer is available for the qualifying spouse (even if the other spouse used the exemption within the past two years).

There are several exceptions to the two-year ownership and use rules. A taxpayer’s period of ownership of a residence includes the period during which the taxpayer’s deceased spouse owned the residence. If an individual becomes physically or mentally incapable of self-care, the individual is considered to use a residence as a principal residence during the time in which the individual owns the residence and resides in a licensed care facility (e.g., a nursing home). For this rule to apply, the taxpayer must have owned and used the residence as a principal residence for an aggregate period of at least one year during the five years preceding the sale or exchange.

Reduced Exclusion
If the principal residence is owned and used for less than two years, a reduced gain exclusion may be available if

  • you owned the home on August 5, 1997, and sold it before August 5, 1999 (regardless of the reason for sale), or
  • the home was sold because of a change in your health, place of employment, or some other unforeseen circumstance. The reduced exclusion calculation is generally based on the lesser of the days used or owned, divided by 730 days.

Provided the ownership and use tests are met, renting the property does not jeopardize the gain exclusion. A taxpayer will qualify for the exclusion if he or she owned and used a home for two years and converted the residence to rental property for up to three years.

Record Keeping
The $250,000 or $500,000 exclusion from income eliminates the need for many home owners to keep records of capital improvements that increase the value of their residences. However, records of capital improvements should be kept if there is any possibility that income might be required to be recognized upon the sale of the principal residence, a situation that might arise if

  • the individuals intend to live in the residence for a long period of time;
  • the residence is rapidly appreciating in value;
  • there is a possibility that the owners may claim a depreciation deduction for a home office or rental use of the residence; or
  • there is a possibility that the owners may not use or own the residence long enough to qualify for the full exclusion.

These regulations are complicated, and this article merely summarizes them. The regulations should be reviewed in their entirety to determine what tax exclusion you are entitled to. Your financial and tax advisers can provide more information and should be consulted before any action is taken.

Milton Zall is a freelance writer who specializes in taxes, investments, and HR/business issues. He is a certified internal auditor and a registered investment adviser. Send your comments or questions regarding this article to tcaw@acs.org or the Editorial Office 1155 16th St., N.W., Washington, DC 20036.

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