IRS sheds light on capital gains exclusion

December 31, 2002

New regs. contain long-awaited details on house-friendly tax law

Inman News Features

The IRS has issued additional reulations on the 1997 tax law that permits home sellers to exclude up to $250,000 (single filer) or $500,000 (married couple filing jointly) from federal capital gains taxation. The exclusion can be used once every two years, but is subject to very complex rules that until now haven't been well understood by taxpayers or tax preparers.

The new regulations clarify the definition of a "principal residence," explain when a capital gain must be allocated to the business use of a home and clarify how taxpayers can meet the requirement of owning and using the home as a principal residence during two of the five years before the home is sold.

The regulations now list factors the IRS has deemed relevant in determining which home is the "principal residence" of people who own more than one home. The factors include the amount of time the homeowner spends living in the home, the homeowner's place of employment, where the homeowner's other family members live, the address the homeowner uses for his or her tax returns, driver's license, car registration, voter registration, bills and correspondence, and the location of the taxpayer's banks, religious organizations or recreational clubs, according to the IRS.

Homeowners don't have to allocate the capital gain from the sale of the home between business and residential use if the business use occurred within the same dwelling unit as the residential use. Tax is payable on the amount of gain equal to the total depreciation taken after May 6, 1997, but can exclude any additional gain on the residence up to the maximum amount. If the business-use property was separate from the residential-use unit, the homeowner would allocate the gain between the two uses and could exclude only the gain on the residential unit, according to the IRS.

The capital gains exclusion may include a gain from the sale of vacant land that had been used as part of the residence if the land sale occurred within two years before or after the sale of the residence.

Joint homeowners who aren't married can exclude up to $250,000 each of capital gain on their own tax returns.

The homeowner must own and use the home as a principal residence for at least two of the five years before the sale to take advantage of the capital gains exclusion. The ownership and use periods need not be concurrent, and the two years may consist of 24 full months or 730 days. Short absences (e.g., a summer vacation) count as periods of use, but longer absences (e.g., a one-year sabbatical) do not count as periods of use.

The IRS issued a temporary for-comment version of these regulations in October 2000 and the regulations issued today are final.

The IRS also is soliciting comment on temporary regulations that deal with an exception to the two-year ownership rule that allows a partial gain exclusion when the primary reason for the home sale is health, a change in the homeowner's place of employment or "unforeseen circumstances." The temporary regulations now are effective, but may be changed when they become finalized.

Homeowners can establish that the home sale was for health reasons, job relocation or unforeseen circumstances by their individual situation. But the IRS also has identified some safe harbor situations that automatically establish that the sale was for one of those reasons.

The job relocation reason is permitted if the new job site is at least 50 miles farther from the old home than the old workplace was from that home. The employment change must occur during the taxpayer's ownership and use of the home as a residence. A qualified person for this reason is the homeowner, his or her spouse, a co-owner of the home or a member of the homeowner's household.

The health reason is permitted if it is related to a disease, illness or injury of the homeowner, his or her spouse, a co-owner of the home, a member of the homeowner's household or certain close relatives. A physician's recommendation of a change in residence for health reasons also will suffice.

The "unforeseen circumstances" reason is permitted for a death, a divorce or a legal separation, becoming eligible for unemployment compensation, a change in employment that leaves homeowner unable to pay the mortgage or reasonable basic living expenses, multiple births resulting from one pregnancy, damage to the home from a natural or man-made disaster or an act of war or terrorism, or the condemnation, seizure or other involuntary conversion of the property. The IRS also has the discretion to categorize other situations as "unforeseen circumstances."

The maximum exclusion amount is limited to the percentage of the two years that the person fulfilled the requirements of the tax law. A seller who experienced one of these situations, owned and occupied the principal residence for, say for example, one year and hadn't excluded a capital gain on the sale of another home during could exclude half the regular maximum amount. The proportion can be figured in days or months, according to the IRS.

Copyright: Inman News Service

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