Third in a series of articles
If you have owned and lived in your home for two years, the law is clear: When you sell, you can exclude from capital gains tax up to $250,000 of the profit if you are single or $500,000 if you are married and file a joint return.
But what if you sell your house before the magic two years spelled out in the tax law?
In 1997, when Congress enacted this legislation, it had absolutely no inkling that the real estate market would be so hot, and that so many homeowners would make so much profit on their home sales, even if they did not own their property for the full two years. However, Congress did provide reduced exclusions if prior to holding the property for the full two years the homeowner had to sell because of a change in employment, health reasons or "unforeseen circumstances."
For more than five years, though, taxpayers were in the dark as to the details of these, particularly as to what the IRS would consider "unforeseen." Finally, on Dec. 24, the IRS issued temporary regulations dealing with sales of homes owned less than two years. The temporary regulations established certain "safe harbors." If taxpayers fall within one of these safety zones, they will automatically be entitled to the appropriate exclusion of gain. If you owned your home for one year, that would be half what would be allowed you under the $250,000/$500,000 exclusion; if you owned for 18 months, it would be 75 percent.
If you sell your house after less than two years and don't fit within one of these safe harbors, then you owe the tax.
Here are some of the new, but temporary, safe harbors:
* Change in employment. The temporary regulations are quite clear: If someone sells a home because his or her new place of employment is at least 50 miles farther away from the home than the old one, the person can take a proportionate exclusion of gain. According to the regulations, a change in employment is defined as "the commencement of employment with a new employer, the continuation of employment with the same employer, or the commencement or continuation of self-employment."
* Health. If a doctor recommends a change of residence for reasons of health, this will be a safe harbor under the new temporary regulations. What determines "health"? According to the IRS, "If the taxpayer's primary reason for the sale is (1) to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury . . . or (2) to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness or injury," then the proportional amount of profit can be excluded. It should be noted that "qualified individuals" include family members who are in need of medical assistance away from the principal residence.
The IRS made it clear, however, that a sale of the family home merely because it is beneficial to the general health or well-being of the taxpayer will not fall within the safe harbor.
* Unforeseen circumstances. Congress passed the buck to the IRS to come up with definitions -- safe harbors -- under this amorphous category. The IRS rose to the challenge by providing that the following events would be considered safe harbors, on the condition that these events involve the taxpayer, his or her spouse, a co-owner of the residence, or a member of the taxpayer's household:
Being terminated from employment and thus eligible for unemployment compensation.
A change in job status that results in the taxpayer being unable to pay the mortgage and reasonable basic living expenses for the taxpayer's household.
Divorce or legal separation.
Multiple births resulting from the same pregnancy.
Involuntary conversion of the property, such as a condemnation by a governmental authority.
Destruction of the property because of a man-made disaster, an act of war or terrorism.
In addition, the IRS kept the safe-harbor door open by allowing the IRS commissioner the right to expand these seven items should the need arise, either generally or in response to a particular situation involving a specific taxpayer.
Even though the regulations technically do not take effect until Dec. 24, 2003, they can be applied retroactively. If you sold your home after May 7, 1997 (when the $250,000/$500,000 exclusions began), and have already filed a tax return for the year in which the sale took place, you have the right to file an amended tax return (using IRS Form 1040X). The temporary regulations provide that the IRS "will not challenge a taxpayer's position that a sale before the effective date of the regulations but on or after May 7, 1997, qualifies for the reduced maximum exclusion . . . if the taxpayer has made a reasonable, good faith effort to comply with the requirements of [the law] and if the sale . . . otherwise qualifies under [the tax law]."
Taxpayers who believe that they could be entitled to claim an exemption because they fall into one of these safe harbors should immediately consult a tax adviser. Stay tuned, however; these are only temporary regulations and may be changed.
Next: Tax treatment of points and home equity loans
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.