In one of the biggest gifts ever to American homeowners, Congress in 1997 passed The Taxpayer Relief Act, a portion of which changed long-standing rules for, and provided a huge break on capital gains taxes on the sale of a principal residence. The Internal Revenue Service has, at long last, finalized the regulations regarding one aspect of that law; how to treat sales that occur outside the two year/five year requirement. The new rules were effective as of August 13, 2004.
Most savvy homeowners probably know The Taxpayer Relief Act by heart, but, for the benefit of persons new to actual or potential homeownership, a quick review.
Homeowners had almost always had the ability to defer paying capital gains tax if within a given period of time they purchased a home more expensive than the one they had sold. A homeowner could keep rolling these capital gains over into new properties virtually forever. But, prior to 1997, there was only one small loophole when it was time to cash out. If at least one owner of a house had obtained the age of 55, then $125,000 in profit from the sale of that, (and all the prior houses) could be excluded from capital gains taxes.
In a day of phenomenally increasing house values, the threat of taxes on profits over $125,000 sometimes made it impossible for a homeowner to downsize to a condominium or even to move in with children or into supportive care. The situation was even worse if the homeowner had refinanced over the years, leaving little actual cash to come out of the sale. Homeowners also had to keep records of capital improvements on all homes that had been excluded from capital gains by the 'buying up' loophole.
The Taxpayer Relief Act changed this A single homeowner can now exempt $250,000 in capital gains from the sale of a principal residence ($500,000 for a married couple or 'certain taxpayers' filing a joint return) providing only that the homeowner had occupied that home as a principal residence for two of the five years preceding the sale. And this can be done over and over again ' as long as a sale does not occur more than once every two years.
While historically low interest rates have been given much of the credit for the booming housing market, there can be little doubt that this new tax law has done a lot to encourage homeowners to speculate in the housing market ' if you love to renovate and don't mind living in a mess, handy-man specials can now provide a full time job - and that it has encouraged the growth of retirement and luxury condominium developments.
But, what Congress gives, the IRS can always take away. And left definitively unanswered since passage of the law is the tax liability of a homeowner who sells a home after owning it for only 12 or even 23 months, or is unable to meet the two out of five year residence requirement.
The IRS published temporary regulations regarding this issue in the Federal Register on December 24, 2002. While some written and other comments were received, no public hearings were requested, and the Treasury Department has now finalized, with some changes, those temporary rules.
The main change is a further exemption for military and foreign service personal that allows them to extend the two out of five year residence period to a total of ten years. Therefore, if a military family owned and lived in a residence for three years and then were sent on temporary assignment to another state for six years, they could extend the clock forward so that two of the three years in residence still fall within the requisite time period, (which would then be eight years.)
The rules regarding other sales that do not meet the basic 2/5 criteria can be summarized fairly simply. If you have to sell your house, you are probably entitled to a partial exemption from capital gains taxes; if you just want to sell, get out your checkbook.
The three underlying reasons for qualifying for an exclusion are:
- A change in employment
- a change in health
- unforeseen circumstances.
The acceptable parameters for changes in health or employment are fairly straightforward. In the case of health, the allowable reasons for an early sale are to 'obtain, provide, or facilitate the diagnosis, cure, mitigation or treatment of disease, illness, or injury'or to provide or obtain medical or personal care for a qualified individual suffering from a disease, illness or injury.' There must be a specific illness; deciding that an ocean view would make one feel a lot better will not suffice.
Permissible employment changes include new employment, continued employment, and the commencement or continuation of self-employment. A 50 mile rule generally obtains, i.e., that the new place of employment is at a distance at least 50 miles farther from the principal residence than the prior place of employment.
Unforeseen circumstances are a little squishier. The regs further define them as 'an event that the taxpayer could not reasonably have anticipated' before purchasing and occupying the residence. There is a laundry list of events, including involuntary conversion of the residence (a taking by eminent domain), natural or man-made disasters, death, loss of job that would qualify the homeowner for unemployment compensation; selected other serious financial reverses; and multiple births resulting from a single pregnancy. In some cases divorce qualifies, but marriage does not appear to do so. The final regulations further state that the 'unforeseen' cannot be a sudden preference for a different residence or an improvement in financial circumstances.
The IRS has set forth a number of 'safe harbor' exemptions which further define (and quite clearly, considering the source) how they can be applied. Qualifying for any of these will allow a taxpayer to take a partial exemption based on the percentage of the two year requirement he owned and/or occupied the house. For example, if a homeowner sold a home after occupying it for 15 months and met one of the safe harbor provisions, he would calculate his exclusion from capital gains tax according to the following formula:
(250,000/ 730) x (15 x 30.42)
where $250,000 is the full exclusion (or $500,000 in the case of a qualified spouse); 730 is two years expressed in days, and 30.42 is the average number of days in a month. In this instance, a homeowner would be able to exclude $156,267 of the proceeds of his sale from capital gains tax.
If none of the safe harbor provisions apply, there is also the alternative of applying to the IRS for a ruling based on special circumstances. Consider, however, that it might make more sense to remain in the home for the remainder of the two year term rather than tussle with that agency.
To read the revisions and all of the safe harbor provisions in their entirety, go to www.irs.gov/pub/irs-regs/td_9152.pdf.