Home Selling Exclusions: A Great Benefit for Homeowners

Written by Posted On Sunday, 29 January 2006 16:00

If you have recently sold your house at a significant profit, and if you have not been keeping up with the tax laws, you will be pleasantly surprised. If you are married, if you meet the legal requirements described below, you can exclude up to $500,000 of the profit you have made. If you are not married, or file a separate tax return, the exclusion is reduced down to $250,000 of profit.

For many years, there were two tax concepts which helped save homeowners from paying a lot of capital gains tax: the "roll-over" and the "once in a lifetime." However, the Taxpayer Relief Act of 1997, signed by President Clinton on August 5, 1997, abolished both of these concepts. The roll-over and the once-in-a-lifetime exemption for homeowners over 55 years of age are real estate and tax history.

Although there are no restrictions on the number of times this exclusion can be used (as compared to the old "once-in-a-lifetime" approach) the law does contain two important conditions:

  1. You must have owned and used the home as your principal residence for two out of five years before the house is sold. If you are married, so long as either spouse meets this requirement, the exclusion of gain applies. Marital status is determined on the date the house is sold. In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirements will include any time that the former spouse actually owned the property before the transfer to the other spouse.

  2. The exclusion is generally applicable once every two years. However, if you are unable to meet the two year ownership (and use) requirements because of a change in employment, health reasons or unforeseen circumstances (which have been defined by regulations promulgated by the IRS), then your exclusion is pro-rated. These pro-rations are complex, and have caused considerable confusion among lawyers, taxpayers and even the IRS.

The new regulations were finally implemented by the IRS in 2004. They provide what the IRS calls "safe harbors" -- i.e. if you fall into a safe harbor category, you are entitled to take the partial exclusion. If, on the other hand, you are not within the safe harbor, then according to the Regulations, "The taxpayer may be eligible to claim a reduced maximum exclusion if the taxpayer establishes, based on the facts and circumstances, that the taxpayer''s primary reason for the sale ... is a change in place of employment, health or unforeseen circumstances."

In other words, if you are not within a safe harbor, you will have to convince the IRS that you nevertheless qualify for the partial exemption.

Let's look at these items separately:

  1. Change in employment: If you have to travel at least 50 miles farther from the house you sold because of a job transfer, or even to take a new job, and the primary purpose of selling your house was because of employment reasons, you will be eligible for the partial exclusion.

    The 50 mile distance is the IRS "safe harbor," provided that the change in place of employment occurred during the time that the taxpayer owned and used the home. However, even if you cannot meet the safe harbor, you still may be able to convince the IRS to allow the partial exemption based on "facts and circumstances." The Regulations include an example of a doctor who sold her condominium and moved only 46 miles away from the previous residence. Because the primary reason for the sale was to allow the doctor quicker access to the hospital for emergency purposes, the IRS would allow the partial exemption based on the facts of this case.

  2. Reasons of Health: Once again, we see the concept of "primary purpose." To qualify for the partial exemption, the primary purpose of selling the house must be based on health.

    The safe harbor here is easy. If the taxpayer's physician recommends a change of residence for reasons of health, the taxpayer will automatically qualify for the partial exclusion. And health is rather broadly defined to include "the diagnosis, cure, mitigation or treatment of disease, illness or injury."

    But the IRS issues a precautionary note: A sale "that is merely beneficial to the general health or well-being of an individual is not a sale ... by reason of health."

  3. Unforseen circumstances: Obviously, this is the more difficult category on which to enact regulations. Each of us -- at one point in time -- will face conditions which could not be anticipated or even imagined before it happened, which significantly impact on our lives -- and on our financial situation.

    Nevertheless, it would be manifestly unfair to be faced with a crisis -- have to sell your house before the two years are up -- and have to pay full tax on the profit you have made. Accordingly, Congress authorized the IRS to issue regulations governing this area.

    According to the new Regulations, a sale "is by reason of unforeseen circumstances if the primary reason for the sale ... is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence."

The IRS then lists several safe harbors:

  • involuntary conversion of the residence -- for example, it was condemned by a governmental agency;

  • natural or man-made disasters or acts or war or terrorism resulting in a casualty to the residence. Clearly, the victims of Hurricane Katrina who lost their house would fall squarely in this category;

  • death of one of the owners of the property;

  • the cessation of employment as a result of which the taxpayer is eligible for unemployment compensation;

  • a change in employment or self-employment status that results in the taxpayer''s inability to pay housing costs and reasonable basic living expenses;

  • divorce or legal separation under a Court decree, or

  • multiple births resulting from the same pregnancy.

These are safe harbors. If you fall within one of these areas -- and have owned and used your house during the time since it was purchased -- you will be entitled to take the partial exclusion of gain.

But, once again, even if you cannot claim a safe harbor, you still may be able to convince the IRS that there are facts and circumstances which forced you to sell your house before the two years were up. The burden will be on you, and as we all know, dealing with the IRS is not easy.

If you are eligible for the partial exclusion -- either because you meet the safe harbor tests or the facts and circumstances test -- this exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is 2 full years. If you are single -- or do not file a joint tax return -- change the $500,000 to $250,000.

The law applies to all principal residences: single family homes, cooperative apartments, and condominium units. If your boat or your mobile home is your principal residence, the exclusion can also be taken. In order to qualify as such, three things are required: sleeping quarters, a toilet, and cooking facilities.

While the new $250/500,000 exclusions sound too good to be true, there is one important fact to remember when calculating the profit you have made, and the tax you may have to pay. Real estate in the Washington metropolitan area has appreciated dramatically over the past half century. Many homeowners realized the "great American dream" over the years, and continued to sell and "buy up." The profit that was made on each sale was deferred under the old roll-over concept. Now, when you sell your last house, and you are married, you can exclude up to $500,000 of profit, but what exactly is your "profit"?

Let us take this example. In 1968, you purchased your first house for $40,000. In 1975, you sold it for $150,000, and purchased a new house for $210,000. For this example, we will ignore such items as home improvements and real estate commissions, although these are expenses which can -- and should -- be taken into consideration in determining your actual profit. Because you deferred $110,000 of profit ($150,000 - $40,000), the basis in your new home is now $100,000. You determine your basis by subtracting the profit from the purchase price (i.e. $210,000 - 110,000).

In 1989, at the peak of the then real-estate market, you sold your home for $400,000 and purchased a new house for $500,000. Because the roll-over was still the law, you had deferred profit of $300,000 ($400,000 - 100,000). The tax basis of your new $500,000 home is only $200,000. Keep in mind that under the old "roll over" rules, every new home you purchased had to take into account the deferred gain which you had made on the sale of your previous home.

Here is where the tax bite may occur. If, for example, you plan to sell your house in the near future, you must calculate and be aware of your basis. If you are married and file a joint tax return (and have lived in the house for at least two out of the past five years), you will not have to pay any capital gains tax unless you sell your house for more than $700,000. But, if your spouse has died, and you can no longer file a joint tax return, you can only shelter up to $250,000 of profit. You or your accountant should make sure that you include the "stepped up" basis of the house in your calculations. This means that half of the value of the house on the date your spouse dies is added to your basis.

This is obviously complicated, and you have to have professional assistance before you sell your house.

It is absolutely critical that you keep all of your records and all of your settlement sheets. Such expenses as home improvements, real estate commissions, fix-up costs, legal and title costs, will reduce your profit -- and thus reduce your tax. If you are ever audited by the IRS, you will be required to produce proof of these expenses.

Read next week's column by Benny L. Kass, entitled, "The Starker (Like Kind) Exchange."

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Benny L Kass

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 LEGAL GROUP, 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.


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