Question: My husband and I have lived in our home for many years. We have been fortunate that it has appreciated significantly. We were planning to sell in a few years and move to a location near our children. We know that we would be able to exclude a lot of our profit when the house is sold. Unfortunately, my husband has just had a stoke and has been placed in a nursing home.

Will this new development impact on our ability to take the profit exclusion?

Answer: It appears that you can still take advantage of the full exemption.

Let's first review the law. If you are married, file a joint income tax return, and have owned and used your house as a principal residence for two out of five years prior to its sale, you can exclude up to $500,000 of the profit you will make. If you are single (or file a separate tax return) you are only allowed to exclude up to $250,000 of your profit.

This is referred to as the "ownership and use" requirements.

But there are exceptions to these rules. In your case, since your husband has had a stroke, this is considered to be an "incapacity." Under the law, if a person becomes physically or mentally incapable of self-care, the time that he or she resides in a licensed care facility such as a nursing home is considered to be the same as living in the principal residence.

And instead of having to meet the two year use test, the law reduces that period of time down to one year. In other words, if your husband has to go to a nursing home, you will still qualify for the full exclusion of gain so long as he lived in the house (i.e. used it as his principal residence) for one of the five years before you sell your house.

It should be noted that when the law states that you must use your house for two years (or one year if your spouse goes into a nursing home), this does not mean continuous use. Short absences for vacations, or out of town job assignments are still counted as periods of use. Indeed, even if you rent out your house for two or three years, so long as you can demonstrate to the Internal Revenue Service that you have owned and used the property as your principal residence for the required time periods, you are eligible for the exclusion of profit.

There are other exceptions to this two year use requirement. If you have do not meet the use and occupancy requirements, you may still be eligible for a "reduced maximum exclusion." If the reason for selling your house was because of (1) a change in place of employment (i.e. the new job is at least 50 miles farther from your home), (2) health reasons, or (3) unforeseen circumstances, you may still be eligible to exclude a portion of your gain. This requires some accounting skills in order to compute the amount of the exclusion you will be able to take. The reduced 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.

Now that your husband has gone into a nursing home, I recommend that you sit down with your tax advisor. Determine what your profit will be if you should sell the property now (or within the next few years). Keep in mind that if you have owned and sold a house prior to l997, you probably used the old "roll-over" law which was then in existence. That old law allowed you to defer any profit you had made when you sold your house, but the profit was used to reduce the tax basis of your new house.

Let's take this simple example: In l980, you purchased a house for $100,000, and sold it for $200,000 in l990. For this example, I will exclude any costs or commissions which were paid, although for tax purposes you want to include all such expenses. In l990, you purchased your current house for $300,000, and now you can sell it for $800,000.

One would naturally assume that you made a profit of $500,000 (800,000 - 300,000).

Wrong! Since you deferred $100,000 based on the old roll over laws, the tax basis of your new house became $200,000. The profit you made on the first sale reduced the basis of your new house.

Once you and your tax advisors have determined what your profit may be when the house is sold, you then have the opportunity to plan your future. Will you make more than $500,000 on your house? If so, you may want to make sure that your house is sold within the time frames required by law so that you can take advantage of the full $500,000 exclusion.

Keep in mind that even if you are not able to exclude the full $500,000, so long as you have owned and used the house for the statutory period of time, you are always eligible to exclude $250,000 of your profit.