Thanks to the Taxpayer Relief Act of 1997, singles can now exclude home sale gains up to $250,000 and married couples filing jointly can exclude up to $500,000. To exclude gains from taxes, you must:

• Own the home as your principal home for at least 2 years out of the 5-year period ending on the sale date, and
• Use the home as your principal home for at least 2 years during the same 5-year period.

When you and your spouse own two homes and file jointly, each spouse can potentially meet the ownership and use tests for one home. In this case, you and your spouse can each claim a separate $250,000 exclusion for each home.

Example: Jim and Jane have a commuter marriage. Each resides in a separate home during the work week, but they join up on weekends and holidays. Each meets the requirements for a $250,000 exclusion and each may claim a $250,000 exclusion.

Planning note: Although each meets the tests for the $250,000 exclusion, they probably fail as a couple to qualify for the joint $500,000 exclusion under the "use" test.

Except for the limited reasons and big planning ideas in the next section, you get no exclusion if you excluded home-sale gain within the 2-year period ending on the date you sell the home in question. In other words, this is a once-every-2-years break and 2 years must usually pass before you can repeat the benefit.

To qualify for the $500,000 joint return exclusion, tax law says "no exclusion" by either spouse for an earlier sale within the 2-year period.

However, gains excluded under the old-law $125,000 rule for sellers age 55 or older do not count against you for purposes of the 2-year rule.

Prorated Gain Exclusions Can Save the Day

Obviously, you meet a catastrophic fate if you fail ownership and use tests. Fortunately, Congress deliberately left two "outs" for those who pay attention (like you and other readers of The Tax Byte).

First, for sales after August 5, 1997, you can qualify for a prorated (reduced) gain exclusion if you fail the ownership or use tests. You simply must own the home on August 5, 1997, and sell by August 5, 1999. To calculate the prorated amount, you multiply the standard gain exclusion maximum ($250,000 or $500,000) by the fraction created by dividing the period you actually met the ownership and use tests by the required 2 years.

Example: You sell in early 1999 after owning your home for only 18 months (you bought on August 1, 1997). If you are in a hot real estate market, you could still have a sizable gain (ask someone who lives in the San Francisco Bay area). Or you could be selling a rental property that you converted into your personal home and lived in for 18 months before selling.

Under the prorated exclusion rule, you are entitled to 75% of the standard amount in both cases (based on meeting the ownership and use tests for 18 months — instead of 24 months — during the 5 years ending on the sale date.) So you can exclude gain up to $187,500 if single and $375,000 if married. Many times, the prorated exclusion will cover your entire gain.

Even if you did not own the home on August 5, 1997 (or sell after August 5, 1999), you may qualify for a prorated exclusion. However, in these cases, your failure to pass the ownership and use tests must be due to a job related move, your health, or other specific "unforeseen circumstances" as the IRS will specify in its yet-to-be-released regulations.

Business or Rental Use of Your Home

If you sell your principal home after having claimed home office or rental property deductions, you may not exclude gain equal to depreciation after May 6, 1997. Tax law treats the May 6th depreciation as "unrecaptured Section 1250 gain" and taxes that gain at a maximum rate of 25%. The 25% sounds burdensome until you consider that you:

• Probably deducted the depreciation when it produced tax benefits greater than the maximum 25% payback rate
• Deducted the depreciation in yours before sale so that you had use of the tax refund money for many years before the payback year

For example, if you used part of your home as an office for the entire 5-year period preceding sale, you pay tax on the appreciated part of the house used as an office. Ditto if you rented part of your home for the same period.

On the other hand, if the office or rental use stopped for at least 2 of the 5 years before sale, you may use the $250,000 or $500,000 exclusion against the entire gain. As noted earlier, you still owe tax on depreciation that you claimed after May 6, 1997.

What if you used the office or rental space as a home for only 1 year during the 5 years before the sale? Are you now required to pay tax on the gain allocable to that part of the house? Maybe, maybe not! You might wriggle off the hook under the prorated gain exclusion rule, although it is unclear exactly how it works in such circumstances. The following illustrates what we think is a very reasonable interpretation.

Example: Assume you are married and have owned your home for at least 5 years before sale. For the last four years, you used a large den and connected bathroom regularly and exclusively as your principal place of business. Based on square footage, you treated 20% of the house as an office and claimed the resulting deductions, including $6,000 of depreciation (say $1,500 of that depreciation is after May 6, 1997). Before depreciation, your home's basis was $300,000. You sell the home for $750,000. Your total gain is $456,000 ($750,000 less basis of $294,000).

The gain on the residence part of the home is $360,000 (80% of the difference between $750,000 and $300,000), and the gain on the office is $96,000 (20% of the difference between $750,000 and $300,000 plus the $6,000 of depreciation). You have to pay tax on the $1,500 of post-May 6, 1997 depreciation, so the amount in question for the office is $94,500.

The maximum possible exclusion is $500,000. Assume you can allocate 80% ($400,000) to the residence part of the home and 20% ($100,000) to the office part.

You exclude the $360,000 gain because you meet the ownership and use tests for that part of the house and can exclude gain up to $400,000.

However, you used the office part as a home for only one year during the relevant 5-year period. Still, you should qualify for a prorated exclusion on that part if you moved for job of health reasons or owned the property on August 5, 1997 and sell by August 5, 1999. Say your move was for job reasons. You can apparently exclude up to $50,000 (50%), based on your 1 year of residential use of the office area. So, you report a taxable gain of only $46,000 ($94,500 less $50,000 plus $1,500) on the office part of the home.

Strategy 1: When you know you are going to sell, violate the home-office rules. That eliminates the office so that you can meet the 2-of-5 test. Now, your entire home can qualify for the gain exclusion (except any post-May 6, 1997 depreciation).

Strategy 2: Alternatively, when gain on the home part of the property exceeds the maximum exclusions of $250,000 to $500,000, allocate nothing to the business or rental portion of the house. With this strategy, you make the entire exclusion an offset to the gain on the home part of your property.

Sale After a Recent Marriage

If you get married and you and the new spouse both own homes, you are each entitled to a $250,000 exclusion, assuming you both meet the qualification rules for your respective properties.

For example, say you marry and decide to live in your home until you find a new home that you both like. Your new spouse can sell the old home and exclude up to $250,000 of gain. This assumes the new spouse owned and used that property as a main home for at least 2-of-the-5 years before sale. If you meet the same rule, you too can exclude up to $250,000 when you sell your home. Further, your sale can occur within 2 years of that sale by your new spouse.

Need more? If you wait until both you and your new spouse occupy your home for at least 2 years, you may exclude up to $500,000 on a joint return. This assumes your sale is more than 2 years after your new spouse's sale.

Sale After a Divorce

If you are divorcing and sell your home but are still married at the end of the year of sale, you can exclude gain up to $500,000 on a joint return, provided that you and your soon to be "ex" meet the ownership and use tests. If you meet the 2-out-of-5 test and own the home jointly or as community property, you can report your sale of your half (or other part) on a separate return (married filing separate or head of household, if applicable) and exclude up to $250,000 of gain. The rules generally allow a soon-to-be-split couple to convert their home equity into cash and go their separate ways without owning Uncle Sam.

Often, the divorcing couple does not sell the home until after the divorce. Fortunately, the gain exclusion rules help here too. When one ex-spouse winds up owning the family home, the second owner gets to count the first party's ownership period if necessary to meet the ownership test. Of course, the maximum exclusion here is only $250,000.

If the spouse who gets the house remarries, he or she can qualify for the full $500,000 exclusion. What's necessary? First, a joint income tax return with the new spouse. Second, the new spouse must occupy the house as a principal home for at least 2 years.

In many cases, ex-spouses continue to co-own the home after the split, but obviously only one party continues to live there. After a few years, the nonresident ex fails the 2-out-of-5 years use test. Then when they sell the home, the nonresident ex pays tax on the full gain. Thankfully, with a little foresight, you can easily avoid this problem.

Do this: Make the divorce papers allow one ex-spouse to use the home owned (or partly owned) by the other party say until the children are grown or for a designated number of years. This allows the nonresident ex to receive "credit" for the other party's continued use of the home. Do not fail to put this language in the divorce agreement or property settlement documents. Failure can result in loss of exclusion for the nonresident ex — a taxing result.

Selling Surrounding Acreage with Your House?

When a home is situated on substantial acreage, the question is: how much land can you sell along with the house and still have the whole transaction qualify for the gain exclusion? Probably quite a bit, as long as you use the property for personal purposes like hiking or horseback riding or simply own surrounding land because you appreciate nature, want to live in wide open spaces, or enjoy having unobstructed views. The Tax Court allowed one taxpayer to treat 43.5 acres as part of his personal home for these kinds of reasons.

If you sell your surrounding acreage in several different transactions as part of an overall effort to unload your home, can you qualify the gains on the "interim" land sales for exclusion? The IRS Revenue Ruling allowed interim sales under the recently replaced gain rollover rules. The current gain exclusion rules do not address multiple sales in discussions of one tax-free sale every 2 years. Legislative history supports the right to claim the exclusion on the sale of one principal home (as opposed to several principal homes sales within 2-year period). Thus, you should qualify for exclusion if you have to sell your home in several parts.

What About Recordkeeping?

As you know, the gain on the eventual sale of your current home will be the difference between your tax basis and the sale price. You may think the whole idea of keeping records of your home's basis has become academic. After all, you do not expect gain greater than $250,000 or $500,000.

Think again before throwing away the evidence that shows how much you sunk into your current home and any earlier homes. Why? Because your home's basis is essentially what you paid, less any gains from earlier sales rolled into your current home, less any depreciation writeoffs claimed on your current home. Your basis may be a whole lot less than what you paid for the house.

In addition, real estate prices are again posting double-digit gains in some areas and healthy increases almost everywhere else. So the price you get on the eventual sale of your home may be much higher than what you expect right now.

Finally, Congress persists in rewriting the tax laws. Today's relatively generous gain exclusion rules may be nothing but a fond memory by the time you sell. Be smart. Protect yourself! Continue tracking the tax basis of your home!