Tax Breaks for Home Sales Can Be Tricky to Compute

Washington Post, January 21, 2006
By Benny L. Kass

It used to be that home sellers who wanted to legally avoid some federal taxes had to master such arcane concepts as "rollovers" and the "once-in-a-lifetime tax exclusion."

But since 1997, when the tax treatment of home sales was changed, it has been a lot simpler: Many homeowners can exclude from taxation up to $250,000 of home sale profit, $500,000 if they are married and file tax returns jointly. There are no age limits or restrictions on the number of times the exclusion can be used.

It's still not completely straightforward. There are important conditions:

· The exclusion is generally applicable just once every two years.

· You must have owned and used the home as your principal residence for two out of five years before the house is sold. If you are married, the exclusion of gain applies if either spouse meets this requirement. Marital status is determined on the date the house is sold. In the event of a divorce in which one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirements will include any time that the nonresident former spouse owned the property before the transfer to the resident former spouse.

If you are unable to meet the two-year ownership and use requirements because of a change in employment, health reasons or unforeseen circumstances (as defined by the Internal Revenue Service), your exclusion is prorated.

The prorating can be complex and has caused considerable confusion among lawyers, taxpayers and even the IRS. The new regulations were finally implemented by the IRS in 2004. They provide what the IRS calls "safe harbors": If you fall into a safe harbor category, you are assumed to be entitled to the partial exclusion. If you are not within the safe harbor, "the taxpayer may be eligible to claim a reduced maximum exclusion if the taxpayer establishes, based on the facts and circumstances, that the taxpayer's primary reason for the sale . . . is a change in place of employment, health or unforeseen circumstances."

In other words, if you are not within a safe harbor, you will have to convince the IRS that you nevertheless qualify for the partial exemption.

Let's look at these items more closely:

· 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 "safe harbor," provided that the change in place of employment occurred while the taxpayer owned and used the home. However, even if you cannot meet the safe harbor, you still may be able to convince 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 46 miles away. 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 the 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. Health is rather broadly defined to include "the diagnosis, cure, mitigation or treatment of disease, illness or injury."

But the IRS issues a precautionary 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."

· Unforeseen circumstances. This is the more difficult category for which to enact regulations. At some point, all of us will face conditions which could not be anticipated, but that significantly affect our lives and our financial situations.

According to the IRS, a sale "is by reason of unforeseen circumstances if the primary reason for the sale . . . is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence."

The IRS then lists several safe harbors:

· Involuntary conversion of the residence. For example, 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. Clearly, the victims of Hurricane Katrina who lost their houses would fall squarely in this category.

· Death of one of the owners of the property.

· Cessation of employment as a result of which the taxpayer is eligible for unemployment compensation.

· 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.

· Multiple births resulting from the same pregnancy.

If you qualify under one of those safe harbors -- and have owned and used your house in the time since it was purchased -- you will be entitled to take the partial exclusion of gain.

But, once again, even if you cannot claim a safe harbor, you still may 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, either because you meet the safe harbor tests or the facts and circumstances test, it is 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.) This works out to be an exclusion prorated by the number of days you lived in the house -- that is, if you lived there one full year and are married filing jointly, you could exclude up to $250,000. (If you are single or do not file a joint tax return change the $500,000 quotient to $250,000.)

The law applies to all principal residences: single-family houses, cooperative apartments and condominium units. If your boat or mobile home is your principal residence, the exclusion also applies.

The $250,000/$500,000 exclusions are a major tax break for homeowners. But that may not mean that you can forget completely about the old rollover tax rules.

Real estate values in the Washington area have appreciated significantly over the past half century. Many homeowners bought and sold to move into bigger homes. The profit that was made on each sale was deferred under the old rollover concept. Now, when you sell your house, you can exclude up to $500,000 of the profit -- but what exactly is your profit? It depends on those long-ago home sales.

Let us take this example: In 1968, you purchased your first house for $40,000. In 1975, you sold it for $150,000, and purchased a new house for $210,000. (For this example, we will ignore such items as home improvements and real estate commissions, although these are expenses that should be taken into consideration in determining your profit.) Because you deferred $110,000 of profit ($150,000 minus $40,000), the basis in your new home is $100,000. You determine your basis by subtracting the profit from the purchase price ($210,000 minus $110,000).

In 1989, you sold your home for $400,000 and purchased a new house for $500,000. Because the rollover was still the law, you deferred profit of $300,000 ($400,000 minus $100,000). The tax basis of your new $500,000 home is only $200,000. Thus, if you sell that house for more than $700,000, you would owe capital gains tax, because your cumulative profit over the years has been more than $500,000.

If you plan to sell your house, you must calculate and be aware of your basis. You could have a lot more profit than you think. You may want professional assistance to help you figure this out before you sell.

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

Next Saturday: The like-kind or Starker exchange.