The Tax Byte

New Regulations Clarify Home
Sale Tax Break

As you know, singles can potentially avoid any federal tax on home sale gains up to $250,000. Married couples filing jointly can exclude as much as $500,000. The two-part qualification rule says the property must have been:

Owned for at least two years out of the five-year period ending on the sale date, and
Used as your principal residence for at least two years during the same five-year period.

To qualify for the $500,000 joint return exclusion, either you or your spouse (or both) must meet the ownership test. You must both meet the use test.

The exclusion is generally unavailable if you excluded an earlier gain within the two-year period ending on the date the residence in question is sold. In other words, you cannot "recycle" the gain exclusion privilege until two years have passed since the last time you took advantage. (However, there's an important exception, as explained later in this article.) To qualify for the full $500,000 joint return exclusion, neither spouse can have claimed an exclusion for an earlier sale within the two-year period.

Those are well-known basics on this important tax break. But many specific taxpayer questions remained unanswered until the recent release of new proposed regulations. The good news: the proposed regulations are mostly taxpayer-friendly, as you will see.

Definition of Residence and Residential Use

The new rules clarify that a principal residence can be a boat, house trailer, or stock held as a tenant-stockholder in a cooperative housing corporation.

They also clarify that, for any given tax year, an individual can have only one principal residence. That will generally be the home where you spend the most time during the year.

Example 1: Say you and your spouse spend seven months out of the year at your home in the city and five months at your home on the beach. The city home is your principal residence for that year. However, you only get to count seven months towards meeting the two-year residential use requirement. "Short" temporary absences for vacations of other reasons still count as periods of residential use (the proposed regulations say absences up to two months are considered "short"). But five months away from the city home is not a "short" absence. So in this case, it would take over three years for you to accumulate the necessary 24 months worth of residential use in the city home. At that point, you could sell the city home and bag the full $500,000 gain exclusion benefit. However as long as your usage pattern stays the same, all the time you spend in the beach home will never count towards the two-year residential use requirement. Why? Because the beach home is never your principal residence. (But see the immediately following discussion for how to get multiple gain exclusions.)

Multiple Tax Breaks for Multiple Homes

If you own several homes, the proposed regulations confirm that you can definitely plan things so each will qualify for the gain exclusion break when you sell.

Example 2: As in Example 1, say you own a city home and a beach home. This time, however, assume you spend 10 months each year at the city home and the remaining two months at the beach home. So the city home qualifies as your principal residence. And you get credit for 12 months worth of residential use each year, because your times away from the city home are only "short" temporary absences for vacation or seasonal reasons. (Note that you get credit for the full 12 months each year even if you rent the city home out during your annual two-month absence.) After owning the city home for at least two years, you sell the property. You qualify for the full gain exclusion ($250,000 if single; $500,000 if married). So far, so good. You can then move into the beach home, use it as your main residence for at least two years, and sell the property. Voila! You now qualify for another $500,000 exclusion, with full IRS blessings. Just make sure there at least two years between the two sales dates.

New Tax-Free Occupation

If you are really paying attention, you probably noticed that Example 2 suggests a terrific tax-avoidance strategy that's perfectly legal. You can basically make a federal-income-tax-free occupation out of purchasing fixer-upper properties, living there for at least two years, and selling out for big profits. You can do this time after time without owing a dime to the Feds (that rhymes nicely).

Example 3: You and your wife have owned and lived in your current home for several years. After reading this newsletter, you decide to buy a fixer-upper home in a good neighborhood and renovate the property. When the renovation is complete, you sell your first home and bag your rightful $500,000 gain exclusion. You then move into the renovated property and buy fixer-upper #2. After two years, you sell the first fixer-upper and bag yet another tax-free gain. You then move into fixer-upper #2 (with the intention of making another tax-free sale two years later) and buy fixer-upper #3. This cycle can be repeated indefinitely. And you'll never owe Uncle Sam a penny of your recurring home sale profits as long as you: (1) meet the ownership and use requirements for each property and (2) make sure your sales are always at least two years apart. Such a deal! Did Congress realize this could happen when the gain exclusion was legislated into existence back in 1997? Probably not. But the tax benefits are there for the taking if you follow this strategy.

Ownership and Use Need Not Overlap

The proposed rules clarify that the required periods of ownership and use need not be during the same time frame. This is an important distinction in certain circumstances.

Example 4: Say you are your spouse rented a home and used it as your main residence for two years. Then you bought the property and rented it out to others for three years before selling. Congratulations! You still qualify for the $500,000 exclusion. Why? Because you owned the property for at least two years during the five-year period before the sale and used it as your main home for at least two years during the same period. The fact that you didn't actually own the property while using it as your main home doesn't hurt your case. You would also qualify for the $500,000 gain exclusion if you rented the property as your own home for two years and then bought it and rented it out to others for three years before selling.

Gain Exclusion Loophole

Obviously, failing to meet the two-out-of-five-year ownership and use tests is a horrible thing when you have a large home sale gain. Ditto if you have two profitable sales less than two years apart. In these cases, you can wind up with a gain that's 100 percent taxable instead of 100 percent tax-free. Yuck!

Fortunately, Congress left a loophole. The new proposed regulations confirm that you can still qualify for a prorated (reduced) gain exclusion when you failure to meet the qualification rules is due to: (1) a change in your job location or (2) health reasons.

Example 5: Say you and your spouse have to sell your principal residence after owning it and living there for only eighteen months. The sale is necessitated by a job transfer (it could be either you or your spouse). Because you are in a hot real estate market, you have a sizable gain despite the brief ownership period. The good news: under the prorated gain exclusion loophole, you qualify to exclude up to $375,000. That's 75 percent of the "normal" $500,000 amount, based on meeting the ownership and use tests for 18 months out of the required 24 (18/24 - 75%). In most cases, the prorated exclusion will be big enough to shelter your entire gain.

Example 6: Same as above, except you finally sold your previous house just 5 months ago and took advantage of the gain exclusion privilege for that earlier sale. The prorated gain exclusion for your current home is now $104,167. That amount is based on having only five months between gain exclusion sales, instead of the required 24 (5/24 x $500,000 - $104,167).

Example 7: Presumably the results in Examples 5 and 6 would be the same if you or your spouse is self-employed. In this case you should be able to move for any reason and still qualify for the prorated gain exclusion loophole -- as long as you qualify for the moving expense deduction on your tax return. However, the gain on the office part of your home may be taxed.

Example 8: Twelve months ago you and your spouse moved into what had previously been a rental income property that you have owned for several years. Now you have to sell and move into a new handicapped accessible home because of a back injury (it could be to you or your spouse). Under the prorated exclusion loophole, you're entitled to a $250,000 exclusion, based on meeting the ownership and use tests for one year instead of the required two (50% x $500,000 = $250,000). Just make sure you have proof that the back problem was the reason for your move. A letter from your doctor would do nicely. Keep the letter with your tax records.

Note: Tax law allows the IRS to specify other "unforeseen circumstances" (beyond job changes and health reasons) when the prorated gain exclusion loophole will be available. Unfortunately, the new proposed regulations do not supply any guidance in this area. Hopefully, we will see something out of the IRS before too long (preferably before next year's tax return filing season begins).

Conclusion

As you can see, the gain exclusion privilege is not all that simple. But it's available in situations that may surprise you, and that's a good thing. In the next issue, we'll tell you more about what the new proposed regulations say, including how to claim a gain exclusion when part of your residence has been rented out or used as a deductible home office. So please stay tuned.