Question: In June of 2005, I sold a house and made a profit of about $245,000. I owned the house for about 17 years. However, I am a Foreign Service Officer, and have only lived in the house 14 months out of the last 15 years. I went on my first overseas assignment in August of 1991, and have rented the house ever since.

Am I entitled to any tax benefits because of my status as a Foreign Service Officer? Is there anything I can do at this stage to avoid paying any capital gains tax -- such as buying another investment property?

Answer: I think you will have to pay the capital gains tax.

Current law allows a homeowner who has owned and used his/her house for 2 out of the five years before it is sold to exclude up to $250,000 of gain ($500,000 if you are married and file a joint tax return).

On November 11, 2003, however, President Bush signed into law the Military Family Tax Relief Act of 2003 (MFTRA), which provides significant benefits for military and foreign service personnel.

According to the IRS:

You can choose to have the 5-year test period for ownership and use suspended during any period you or your spouse serve on "qualified official extended duty" as a member of the uniformed services or Foreign Service of the United States. This means that you may be able to meet the 2-year use test even if, because of your service, you -- did not actually live in your home for at least the required 2 years during the 5-year period ending on the date of sale.

The period of suspension cannot last more than 10 years. Together, the 10-year suspension period and the 5-year test period can be as long as, but no more than, 15 years. You cannot suspend the 5-year period for more than one property at a time. You can revoke your choice to suspend the 5-year period at any time.

The IRS gives an example which is very helpful. Mary bought a home on April 1, 1989. She used it as her main home until September 1, 1992, when she went on qualified official extended duty with the Navy. She did not live in the house again before selling it on August 1, 2005. Mary elects to use the entire 10-year suspension period. Therefore, the suspension period would extend back from August 1, 2005, to August 1, 1995, and the 5-year test period would extend back to August 1, 1990. During that period, Mary owned the house all 5 years and lived in it as her main home from August 1, 1990, until September 1, 1992 – a period of 25 months. She meets the ownership and use tests because she owned and lived in the home for 2 years during this test period.

(Selling Your Home, IRS Publication 523)

Now, let's look at your example. You sold your house in June of 2005. Thus, according to the law (and the IRS) you can look back 15 years -- to June of 1990. In order to take advantage of the full $250,000 exclusion (or $500,000 if you are married), you had to live in the house for a full two years beginning after June of 1990.

However, you have advised that you only lived there for 14 months -- 10 months short of the test period.

There is another provision in the tax law which allows a homeowner a partial exclusion of gain (called a reduced maximum exclusion). If you are required to sell your home because of any of the following three categories, you may be able to get a break on your capital gains tax payment: (a) a change in employment; (b) health reasons, or (c) unforeseen circumstances. In this last category, the IRS includes such matters as:

• death;

• unemployment (if the taxpayer is eligible for unemployment compensation);

• a change in employment status that results in your inability to pay reasonable living expenses;

• divorce or legal separation, or

• multiple births resulting from the same pregnancy.

The reduced exclusion is determined by multiplying the maximum allowable exclusion (i.e. $250,000 or $500,000) by a fraction.

The denominator of this fraction is either 730 days or 24 months (depending on the time of ownership involved), and the numerator is the shortest of (1) the period of time that the taxpayer owned the property during the five year period, (2) the period of time that the homeowner used the property as the principal residence or (3) the period of time between the date of the prior sale of property for which the taxpayer excluded gain as a sale and the date of the current sale.

Obviously this is complicated and requires professional assistance to determine the amount of the partial exclusion.

However, all of these factors are applicable only if they are the primary reason why the homeowner has to sell before the two year test period has run.

In your case, it does not appear that you were forced to sell. I suspect that the good market was one of the primary reasons why you sold, and unfortunately, that is not going to fly with the IRS.

You also asked if there is any way to avoid paying the capital gains tax. The Federal tax currently is 15 percent of your net profit and depending on which state your property is located, you may also have to pay State tax.

It is too late to try to shelter that profit. You could have entered into a 1031 exchange (called a "Starker" exchange) but that had to occur at the time you sold your house. All of the sales proceeds have to be escrowed, and used directly for the purchase of the replacement property. In order to have a successful Starker exchange, you are absolutely prohibited from having any access -- or any control -- over the escrowed funds. And clearly, in your case, you have had the money since June.

Accordingly, you will have to pay the tax. You want to carefully review all of your records since you first purchased the house. Any improvements which you have made to the property will increase your tax basis -- and thus lower the amount of tax you will have to pay.

I suggest that you discuss this with your tax accountant, with a view of taking every legal step available so that your capital gains tax can be reduced.

Published: December 19, 2005

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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.