Save Your Tax Exemption When You Can't Sell?

By Benny L. Kass
Saturday, October 17, 2009

Q: After living in the Washington area my entire life (I'm now 68), my wife and I retired to another state in January 2007. We tried to sell our Virginia condo while purchasing a new home where we now live. The D.C. market was in bad shape, and we were unable to sell. We decided to rent our condo until the market settled. Unfortunately, this still hasn't happened.

This presents quite a problem for us in the future when we try again to sell the condo. I believe the Internal Revenue Service rule says that we must occupy the property being sold for two of the five years prior to the sale to avoid paying capital gains tax. This means that to avoid this crippling tax, we would have to move back to Virginia and live in the condo for two years before trying to sell.

Is there any way we can avoid this situation? We lived in the condo for 25 years and never intended to use it as a rental property. People like us who were put into this situation shouldn't be penalized like this. Everyone else seems to be getting breaks from the federal government, and I think we deserve one, too.

A: Yes, you do deserve a break, and there may be a way to solve your problem.

First, you are correct. In order to qualify for the up-to-$500,000 exclusion of profit you may make when you sell your house (if you file a separate tax return the limit is $250,000), you must have owned and lived in it for two out of the five years before it is sold. You moved out in 2007.

Since you have already lived there for two years, have you considered dropping the price so that you can meet the five-year deadline, which would be sometime in 2009? Keep in mind that you do not have to live in the condo all of the time. So long as you can show that you lived there for two years (or 730 days), you should be able to qualify for the exclusion.

You have owned the condo for many years. I suspect that you will have made a large profit, and clearly you want to do everything legally possible to preserve your right to exclude this gain.

Alternatively, if you can move back and live there one more year, you would have a little more time in which to take advantage of the gain exclusion. Everyone must carefully do the math to make sure you can prove two-year occupancy.

If you are ever audited by the IRS, you would also have to demonstrate that this was really your principal residence. Where do you vote? What state gave you your car registration and your driver's license? In reality, it is not easy to move back into the house after you bought another one somewhere else.

There is another approach that you may want to consider. However, a strong caveat is in order: To my knowledge, this approach has not been approved or authorized by the IRS.

Before 1997, when Congress enacted the Tax Reform Act authorizing the exclusion of up to $500,000 of gain, homeowners could take advantage of what was known as the "rollover." Under this approach, if you sold your principal residence, and within two years before or after the date of the sale you purchased another property, you were able to defer any gain you made on the sale. The gain was deducted from the sales price of the new house so that your tax basis was lowered.

The rollover no longer is law.

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