Tax exclusions offer big benefit to home sellers

Saturday, January 30, 2010; E03

"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."

-- Ogden Nash

Many home sellers made little profit or sold at a loss last year. But homeowners who bought years ago and benefited from the huge gains during the first part of this century might be pleasantly surprised. If you are married and 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 to $250,000 of the profit. You will not have to pay any tax on that portion of the excluded profit. For many years, two tax concepts helped save sellers from paying a lot of capital gains tax: The "roll-over" rule, which required that sellers buy another home that cost at least as much as the old one, and the "once in a lifetime" exemption for homeowners older than 55. But both were abolished in 1997. What exists is the $500,000/$250,000 capital gains exclusion. There are no restrictions on the number of times this exclusion can be used, but the law contains two important conditions:

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, husband and wife must meet the use test, but only one spouse has to meet the ownership test. If you cannot qualify jointly, but one spouse can meet both tests, he or she can claim the up-to-$250,000 gain exclusion.

In the event of a divorce, the use requirements will include any time that the former spouse 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 can take the full $500,000 exclusion.

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 the IRS), then your exclusion is prorated. These prorations are complex and have caused considerable confusion among lawyers, taxpayers and the Internal Revenue Service.

The IRS regulations allow taxpayers to claim a partial exclusion if they sold the home because of a change in the place of employment, health or unforseen circumstances. Let's look at these items separately:

Change in employment: If you have to travel at least 50 miles farther from the house you sold because of a job transfer or 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's "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 might be able to persuade 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 her 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.

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 cautionary 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."

Unforseen circumstances: Obviously, this is the most difficult category on which to enact regulations. Each of us, at some point, will face conditions that could not have been anticipated or even imagined, but which will significantly impact our lives and our financial situations.

Nevertheless, it would be manifestly unfair to be faced with a crisis -- requiring you 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 also list several "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:

-- Involuntary conversion of the residence, for example, if you lost ownership because 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. 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.

But, once again, even if you cannot claim a safe harbor, you might be able to convince the IRS that there are facts and circumstances that 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 will be equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is two 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. To qualify, three things are required: sleeping quarters, a toilet and cooking facilities.

As with everything dealing with taxes, talk with your financial and legal advisers before you list your property. You can also find good material on the IRS Web site, http://www.irs.gov. Look for Publication 523, Selling Your Home.

It is critical that you keep all of your records and all of your settlement sheets. Such expenses as home improvements, real estate commissions, and legal and title costs will reduce your profit -- and thus reduce your tax. If you are audited by the IRS, you will be required to produce proof of these expenses.

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.