Second in a series of articles
In 1997, Congress gave American homeowners a huge tax break. People who own and live in a home for two of the five years before they sell it have been able to completely exclude from capital gains tax their profit of up to $250,000 if they are single and $500,000 if they are married and filing jointly.
More than five years later, on Dec. 23, the Internal Revenue Service issued two sets of regulations -- one final and one temporary -- attempting to clarify a number of issues relating to the interpretation of that tax law.
The regulations are lengthy (34 pages) and unfortunately have not clarified all the concerns raised since 1997 by both homeowners and tax practitioners. Nevertheless, the regulations exist, and if you have sold your house within the past four years, you or your tax advisers should review your situation to make sure that you have properly taken advantage of the law and now the regulations. You may want to file an amended return.
According to an IRS announcement: "A taxpayer who now qualifies for a reduced maximum exclusion and has already reported a gain from the sale of a residence on a prior year's tax return may use Form 1040X to file an amended return claiming the exclusion. Taxpayers may generally amend returns until three years from the original due date. The law did not require taxpayers to meet one of the exceptions before using the reduced maximum exclusion for homes owned on August 8, 1997 (i.e., the year the new law was enacted) and sold within two years after that date. Thus, nearly all taxpayers qualifying under these regulations should be able to use them by amending a recent year's return." (Emphasis added).
The IRS issued two sets of regulations: final regulations relating to "exclusion of gain from sale or exchange of a Principal Residence," and temporary regulations discussing the reduced maximum exclusion of gain from sale or exchange of a principal residence.
This column will address the final regulations. Next week, I will explore and try to explain the temporary regulations, which involve situations where the taxpayer did not live in and use the property for the full two-year period.
At first blush, the 1997 law appears very clear: If you have owned -- and used -- real estate as your principal residence for at least two years during the five-year period ending on the date that property is sold, you can exclude up to $500,000 of your gain if you are married and filing jointly, or up to $250,000 if you are single or married filing separately.
But homeowners and their tax lawyers raised a number of questions. Now the IRS has attempted to provide some answers. This column can only highlight the issues; if you think these new regulations might affect you, you are strongly encouraged to seek your own financial and legal assistance, because every situation is different.
Among the issues covered by these final regulations:
* Principal residence. What is a principal residence? The age-old test used by the courts and the IRS is called the "facts and circumstances" test. The IRS has consistently refused to provide a definitive response, and instead relied on this test. However, now the IRS has at least provided some guidance. According to the regulations, "the residence that the taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayer's principal residence . . . [but] this test is not dispositive," or conclusive.
* Vacant land. Before 1997, a sale of vacant land that did not include a dwelling house did not qualify as a sale of the taxpayer's residence. In most cases, such a sale would trigger capital gain. Now, under the regulations, if the land is adjacent to the principal residence, and the residence has been owned and used by the taxpayer for two out of the five years, so long as the sale of the principal residence occurs within two years before or after the sale of the vacant lot, it will qualify for the exclusion. However, the sales are treated as only one sale; the taxpayer cannot exclude from gain more than the $250,000/$500,000 exclusion.
* Occupancy. When the IRS issued draft rules for comment by the public, many people urged the agency not to require actual occupancy. The commentators urged the IRS to allow the taxpayer who, although not physically occupying the property, would still be able to call the property his "principal residence" as long as he did not intend to abandon the property as such.
The IRS rejected this request. Accordingly, although the regulations do not require continuous occupancy, to qualify for the exclusion, the taxpayer must prove that he or she has lived in the property for a full 24 months (or 730 days). Short absences, such as vacation or other seasonal absences, are permitted. A one-year sabbatical is not.
* Allocation between residential and nonresidential. Let's take this example: One room in your house is exclusively used for your business. You allocate the business use to one-fifth of your property. Each year, you depreciate a portion of your expenses on your tax returns. Over the years, you have taken $10,000 of depreciation. You sell your home and have made an overall profit of $50,000.
Initially, the IRS was considering an allocation requirement -- namely if the residence is used partially for residential purposes and partially for business purposes (i.e. mixed-use property), only that portion of the gain that could be allocated to the residential use could be excluded. Thus, in our example, only four-fifths of the $50,000 profit would be eligible for the exclusion.
However, the IRS reconsidered its opinion. If the business use occurred within the same property as the residential use, the taxpayer must pay tax on the gain equal to the total depreciation he took after May 6, 1997, but may exclude any additional gain on the principal residence up to the maximum amount allowable. If the nonresidential portion of the property is separate from the principal dwelling -- for example, a separate garage used for the business -- the taxpayer would have to allocate the gain between the business and the residential, and would be allowed to exclude the gain only on the residential unit.
This was a compromise on the part of the IRS on a very significant -- and complex -- issue. It becomes more and more significant as we move into an era where a lot of taxpayers are either working from home or setting up home-based businesses.
* Unmarried joint owners. The IRS clarified an issue that has been a great concern to a lot of property owners. For joint owners who are not married, so long as the owners qualify for the exclusion -- in other words meet the use and occupancy requirements -- each owner can exclude up to $250,000 of gain attributable to his or her respective interest in the property.
This last clause is significant. If two people own property as joint tenants or tenants in common on a 50-50 basis, then each can exclude up to $250,000 of his of her share of the gain. However, if one person owns 75 percent of the property, that owner can exclude 75 percent of the gain (not to exceed $250,000), and the other owner can exclude the remaining 25 percent -- again, not to exceed $250,000.
* Ownership by trusts. Trusts have become a popular ownership tool in recent years. For a number of reasons -- including tax purposes, estate planning or merely to hide assets from public view -- property is being transferred into some kind of trust.
The IRS clarified and simplified the rules. If the residence is held by a trust, the taxpayer is still considered as owning the property for purposes of complying with the two-year use-and-ownership requirements. For all practical purposes, the IRS will look to the facts and circumstances of the owner, not the trust.
Next week: The new IRS temporary regulations affecting people who did not own a property for the full two years.
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.