The Internal Revenue Service is nearing completion of final regulations that will govern whether -- and how much -- millions of Americans have to pay in federal taxes on their home sale profits.

An IRS official confirmed to Realty Times that the agency should be releasing its long-awaited rules on the $250,000-$500,000 capital gains tax exclusion for home real estate in the coming months. The official could not be certain, however, that the rules would be out in time to guide home sellers on their 2001 transactions.

Among the key issues to be clarified:

• How can people who've owned their houses for relatively short periods of time -- less than the two-year statutory minimum -- qualify for a piece of the tax-free exclusions when they sell?

• Can they qualify for capital gains relief when they're forced to sell earlier than planned because of "unforeseen circumstances?"

• Should workers who are transferred overseas by their employers -- private or public -- be penalized by the federal tax code when they return and sell their houses for a profit?

Under congressional reforms to the tax code enacted in 1997 and 1998, taxpayers can exclude up to $250,000 (single filers) or $500,000 (joint filers) of profits on the sale of a home, provided it was owned and used as a principal residence for at least two of the five years preceding the sale.

Taxpayers who sell before the minimum two-year period because of a change in place of employment, health or because of unforeseen circumstances may be eligible for a reduced tax-free exclusion.

Generally the exclusion in such cases is on a pro-rata basis: For example, if you were hospitalized after one year of ownership and sold your house at a profit, you could qualify for one half of the maximum $250,000 tax-free exclusion, even though you resided in and owned the house for less than the two year requirement. Ditto if you were forced to sell after a year because you were transferred by your employer.

But what did Congress really mean when it allowed homeowners encountering "unforeseen circumstances" to qualify for special capital gains tax relief? That has been the key issue IRS regulation writers have wrestled with for the past year.

Should the vaguely-worded "unforeseen circumstances" waiver be extended to anybody who wants a piece of the $250,000/$500,000 exclusion, and conjures up a sad story to explain an early sale? After all, just about everything can be construed as "unforeseen"--including unpleasant neighbors, unusually bad weather, tomorrow's headlines, you name it.

When the IRS asked for professional guidance on how to set limits on the meaning of "unforeseen circumstances" for home-sale capital gains purposes, here's what the American Institute of Certified Public Accountants and the National Association of Realtors recommended:

• Divorce or legal separation forcing sale of a home prematurely.

• Death of a spouse, family member or co-owner.

• A change in the health status of a family member who is not an owner of the property and doesn't necessarily even live in it. Such an unforeseen circumstance could force a homeowner to sell and change locations in order to care for the ill family member.

• Financial hardships that affect the owners' ability to keep paying for the house. Here the facts might vary widely -- for instance, the loss of a job by a family member living in but not owning the home -- that forces sale before the two year minimum holding period.

Ultimately, the IRS standard is likely to be a "facts and circumstances" test of some type. But based on the relatively strict recommendations received from professional groups, the final rules probably will take a dim view of blatantly hoked-up stories claiming "unforeseen" reasons for selling houses prior to the two-year congressional standard.

If you sold early because you didn't like your next-door neighbors' barking dogs, for example, don't look for any sympathy or tax relief in 2002 from the IRS.

A second issue before the regulation writers concerned homeowners who are transferred abroad by employers for extended periods, and then return and sell their houses. Under earlier IRS proposals, employees' time overseas would not count toward the minimum two-year ownership and use test because they are not physically occupying the property. But real estate groups have asked the IRS to soften that standard, arguing that overseas employees who pay the mortgage and property taxes on a home are "owners" in fact, even if they are not occupying the residence.

For more articles by Ken Harney, please press here.

Published: December 31, 2001

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.