Q: Here is our story. We settled on the sale of our principal residence in June of last year, and purchased another home. We lived in the former property seven months a year for over eight years. Our car was registered there, and we voted there. We have been following this schedule in our current home. We also have utility bills which can verify this arrangement. We also have a second (vacation) home where we live five months a year We plan to sell this second home on or after June of 2003 for a profit of less than $250,000. It is our understanding that since we will have lived in the second home for more than two years, and since the profit will be less than $250,000, we will not have to pay any capital gains tax.

A friend asked the IRS and his own tax consultant about our situation, and both advised that our profit on the sale of our second home will be taxed because it is not our primary or principal residence.

Are they correct?

A: Yes.

The tax law which was enacted in l997 gave a tremendous windfall to the American homeowner – but the home had to be the principal residence. According to the current state of the tax law, if you have used your property as your principal residence for two out of the last five years before it is sold, you can exclude up to $250,000 of your profit if you file a separate (or single) tax return, or up to $500,000 if you are married and file a joint tax return.

But what is a principal residence? There is absolutely no concrete definition given either in the law, in the IRS regulations or in the case law as determined by our law courts. If you ask an IRS agent -- or your tax attorney -- for a definition, she will advise you that "whether or not property is used by the taxpayer as his principal residence . . . depends on all the facts and circumstances in each case, including the good faith of the taxpayer."

There have been very few court cases in which this concept has been defined, and in each opinion, the courts give the same answer: we will investigate the facts of each case, and make our decision based on those specific facts, on a case-by-case basis.

What facts does the IRS (or the Courts) look for in making a determination as to whether the house is – or is not – your principal residence? Here are some of the key elements:

• voting: where are you registered to vote?
• driver’s license: in what jurisdiction is your car registered, and which jurisdiction has issued you a driver’s license?
• utility bill: where do you spend most of your time? Bills from the telephone, electric or gas companies will probably show usage, so as to prove where you were living, and when.

Thus, by your own admission, the home which you bought in June of 2001, is your principal residence. You spend more than half a year in that home, and all of the indicia of ownership can be traced to that property. The favorable tax laws would apply if you sold your principal residence after June of 2003 but unfortunately, they will not apply when and if you sell the second home.

If you will make a profit on the sale of that vacation home, you will have to pay capital gains tax, and currently – for the majority of American taxpayers – the rate is 20 percent.

A couple of years ago, the IRS issued proposed regulations attempting to clarify the 1997 law. A public hearing on these proposals was held on January 23, 2001, but to date the regulations have not yet been finalized. In their proposals, the IRS states:

The requirements of ownership and use for periods aggregating 2 years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 x 2).

Thus, if you want to avoid having to pay tax on the vacation home, you should immediately change your schedule, so that the majority of your time is spent there. Change all of the indicia of ownership to that new location (driver’s license, car registration, voting). Once you can demonstrate that you have lived and used the vacation home as your principal residence for a full two years, you can sell it and take the $250,000 (or $500,000) exemption.

After that property is sold, you can then change your principal residence back to where it was earlier. What is the tax situation if you then decide to sell this house?

There are two important points to keep in mind:

Published: November 11, 2002

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Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.