Make the Most Of the Home-Sale Tax Break

By Benny L. Kass
Saturday, January 17, 2009

Third in a series of articles

"The hardest thing in the world to understand is the income tax."

-- Albert Einstein

Selling your house used to be easy. You listed it with a real estate agent, and in a few days you were deluged with offers -- some higher than your offering price.

Today, a house can sit on the market for weeks or months before you get an offer. And your potential buyer must jump many hurdles and have an excellent credit rating to get a mortgage loan commitment.

But when the house finally sells, you can take advantage of one of the greatest tax breaks available: If you make a profit, a big chunk of it is tax-free.

If you have owned and lived in your principal residence for two out of the five years before it is sold, up to $500,000 of any profit can be excluded from federal capital gains tax if you are married and file jointly. (It's $250,000 for taxpayers who are single or married filing separately.)

This is known as the "use and ownership" test.

Use does not have to be continuous. As long as you can prove that you have lived in the house for two full years, that will satisfy the Internal Revenue Service. And you do not have to live in the house every day. It does not void your use claim if you take a vacation or even move to the beach for a couple of weeks every summer.

The law appears straightforward. But each of us has a different set of facts. Let's explore some situations:

· Death of a spouse. Say you and your spouse owned and lived in the house for years, but last year your spouse died. Current law allows the surviving spouse to claim the full $500,000 exclusion if the sale is not made later than two years after the death, as long as both the use and ownership tests had been met at the time of death. To qualify for the full exclusion, the surviving spouse must not have remarried before the sale of the house.

· Tax liens. If you are delinquent with your income tax payments, the IRS can (and will) slap a tax lien against you and your home. The IRS said it issues more than 600,000 tax-lien notices every year. There are more than 1 million such liens outstanding, many involving real estate.

If there is such a tax lien, you cannot sell your house without first dealing with the IRS. In the past, it could take months to resolve any such issues. However, on Dec. 16, the IRS announced an expedited process to make it easier for financially distressed homeowners to sell or refinance.

Homeowners have a number of options. If you are planning to refinance -- or if your lender is prepared to restructure your loan to make the monthly mortgage payments more attractive -- you can ask the IRS to subordinate its lien. This means that while the lien will remain on the land records, it will be in second place, behind your current lender. When a lender makes you a mortgage loan, it wants to be sure that it will be in first-trust position. Should it have to foreclose, there will be no lienholder ahead of it.

If you are selling your house for less than you owe your mortgage lender -- called a "short sale" -- you can also ask the IRS to completely discharge its claim. According to the agency, the process for requesting a discharge or a subordination of a tax lien will take about 30 days after receiving the formal request.

"We don't want the IRS to be a barrier to people saving or selling their homes. We want to raise awareness of these lien options and to speed our decision-making process so people can refinance their mortgages or sell their homes," said Doug Shulman, the IRS commissioner. (To apply for lien subordination, see IRS Publication 784; for lien discharge, see Publication 783. Both publications are available free at

· Married couples. Although I believe that married people should own their home together, there are many homes owned by only one spouse. This does not affect a couple's ability to claim the full up-to-$500,000 exclusion. As long as either spouse meets the ownership test and both meet the use test, they can claim the full exclusion. However, if one spouse has already claimed the exclusion on another property within the past two years, the exclusion is limited to $250,000.

This is common when people marry and then want to sell their respective houses and buy one together. Careful planning is required to maximize the exclusions. Couples should consult with their financial and tax advisers before they sign any real estate contracts.

· Divorce. If you are divorced when the house is sold, as long as both parties meet the use and occupancy tests, each has the right to claim their own up-to-$250,000 exclusion of gain. But what if one spouse moves out of the house pursuant to a divorce or separation agreement and the house is sold several years later? According to the IRS, "if your home was transferred to you by your spouse (or former spouse if the transfer was incident to divorce), you are considered to have owned it during any period of time when your spouse owned it."

Additionally, in order to meet the use test, "you are considered to have used property as your main home during any period" when you own it and your spouse or former spouse is allowed to live in it under a divorce or separation instrument and uses it as his or her main home.

If you can meet both the use and occupancy tests, it makes no difference when the home was sold; you may be able to claim the up-to-$250,000 exclusion. Again, discuss your situation with your tax advisers. And if you are in the process of getting a divorce, make sure that you address the tax consequences of selling the family home in your legal separation agreement.

· Reduced minimum exclusion. If you have to sell your house and cannot meet the use and ownership tests, you may still be able to claim a partial (reduced) exclusion of any gain you have made. If the sale is a result of a change in where you work, health considerations or unforeseen circumstances, there is a formula to determine exactly how much of your gain can be sheltered.

For more information and details about how to compute your exclusion, see IRS-issued Publication 523, "Selling Your Home," available free from

Next Saturday: tax-deferred exchanges.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site,

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