QWe settled on the sale of our principal residence in June 2001 and bought another home. We lived in the former property seven months a year for more than eight years. Our car was registered there and we voted there. We have been following this schedule in our current home and we have utility bills that can verify this arrangement. We also have a second, or vacation, home where we live five months a year. We plan to sell this second home in or after June 2003 for a profit of less than $250,000. It is our understanding that because we will have lived in the second home for more than two years, and since the profit will be less than $250,000, we will not have to pay any capital-gains tax.
A friend asked the IRS and his own tax consultant about our situation, and both advised that our profit on the sale of our second home will be taxed because it is not our primary or principal residence.
Are they correct?
AYes. The tax law enacted in 1997 gave a tremendous benefit to the American home seller, but the home had to be the principal residence. According to the current tax law, if you have used your property as your principal residence for two out of the last five years before it is sold, you can exclude up to $250,000 of your profit if you file a separate (or single) tax return, or up to $500,000 if you are married and file a joint tax return.
But what is a principal residence? There is absolutely no concrete definition given in the law, the IRS regulations or the case law as determined by our courts. If you ask an IRS agent or a tax lawyer for a definition, you will be advised that "whether or not property is used by the taxpayer as his principal residence . . . depends on all the facts and circumstances in each case, including the good faith of the taxpayer."
There have been very few court cases in which this concept has been defined. In each opinion, the courts give the same answer: We will investigate the facts of each case and make our decision based on those specific facts, on a case-by-case basis.
What facts do the IRS or the courts look for in determining whether the house is -- or is not -- your principal residence? Here are some key elements:
* Voting. Where are you registered to vote?
* Driver's license. In what jurisdiction is your car registered, and which jurisdiction has issued you a driver's license?
* Utility bill. Where do you spend most of your time? Bills from the telephone, electric or gas companies will probably show use, thus proving where you were living and when.
Thus, by your own admission, the home you bought in June 2001 is your principal residence. You spend more than half a year in that home, and all of the indications of ownership can be traced to that property. The favorable tax laws would apply if you sold your principal residence after June 2003. Unfortunately, they will not apply when and if you sell the second home.
If you make a profit on the sale of that vacation home, you will have to pay capital-gains tax. For the majority of American taxpayers, the rate is 20 percent.
A couple of years ago, the IRS proposed regulations attempting to clarify the 1997 law. A public hearing on those proposals was held Jan. 23, 2001, but the regulations have not been finalized. In its proposals, the IRS states, "The requirements of ownership and use for periods aggregating 2 years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 times 2)."
Thus, if you want to avoid having to pay tax on the vacation home, you should immediately change your schedule so that the majority of your time is spent there. Change all the indications of ownership to that new location, including driver's license, car registration and voting precinct. Once you can demonstrate that you have lived in and used the vacation home as your principal residence for a full two years, you can sell it and take the $250,000 (or $500,000) exemption.
After that property is sold, you can change your principal residence back to where it was earlier. What is the tax situation if you then decide to sell this house?
There are two important points to keep in mind:
* Unlike under the tax law before 1997, where you only received a once-in-a-lifetime exclusion, there is no limit on the number of times you can claim this $250,000/$500,000 exemption. The only restriction: You can only claim this exemption once every two years.
* The two-year requirement for personal use and occupancy does not have to be continuous. According to the proposed IRS regulations, "the requirements . . . may be satisfied during nonconcurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale."
The tax laws for homeowners are favorable, and with clever tax planning, you can save a lot of money. But the laws are complex, and the IRS regulations have not been promulgated. You must seek professional tax advice before you embark on any tax journey.
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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.