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IRS Issues Home Sweet Home Sale Rules
Even though the IRS changed the rules regarding the sale of a primary residence more than a decade ago, I still find many clients misunderstand the rules regarding such a sale.
In 1997, Congress passed a law that allows homeowners to sell their principal residence and pocket up to $500,000 in profits without paying any tax on those gains. Generally, the law applies to taxpayers who own and live in their home for at least two out of the five years before the sale. Qualified single homeowners can exclude up to $250,000 in profits from capital-gains taxes, and married couples filing jointly can exclude up to $500,000.
People who live in their home fewer than two years can take a reduced tax exclusion, but only under limited circumstances. The new temporary guidelines not only clarify those exceptions, but carve out some additional tax breaks.
The regulations cover three major exceptions to the two-year qualification rules: a change of employment, health reasons and the catchall “unforeseen circumstances.”
Change of employment. You may qualify for a tax savings if you sell your home in fewer than two years from the time of purchase if a “qualified member” of your household-you, a spouse, a co-owner or household member-moves due to a job change. To qualify, you must move at least 50 miles farther than the distance your old home was from your old place of work, though you may qualify under some circumstances even if the distance is less then 50 miles.
Health reasons. You may qualify if you must move in order to diagnose or treat a disease, illness or injury for a qualified person, or to receive care for that medical problem. This provision includes cases where you move to care for a sick relative.
Unforeseen circumstances. This phrase wasn’t defined in the original legislation. Unforeseen circumstances defined by the IRS now include death, divorce or separation, pregnancy involving multiple births, the sale of your residence because of government seizure, loss due to a man-made disaster or act of war, and severe debt problems.
How do you calculate the reduced exclusion amount? Say you and your spouse are forced to sell your home 18 months after you buy it due to a job change. The reduced exclusion amount is a percentage of the maximum excluded amount based on the time you lived in the house. In this case, you divide 18 months by 24 months (the 2-year minimum), which is 75 percent. Thus, you can shelter up to 75 percent of the $500,000 maximum normally allowed - $375,000 in profits. Most married couples won’t earn that much profit from a shortened sale, so they usually will be able to shelter their entire profits.
By the way, the new regulations also clarify that profit from the sale of vacant land attached to the principal residence is eligible for exclusion as long as the land is sold concurrently or within two years before or after the sale of the residence.
The IRS threw in a bonus for taxpayers who work out of a qualified home office. Home-office taxpayers have long been able to take numerous deductions, ranging from a percentage of household utilities and mortgage interest to depreciation. The catch has been that the portion of the gain from the sale of the home attributable to the portion of the house occupied by the home office was subject to tax. For example, if you made a $100,000 profit, and your home office occupied ten percent of the house, $10,000 was subject to a capital-gains tax.
The new rules now allow the home office portion to be sheltered along with the rest of the residence, with one exception-there’s still a recapture tax on any depreciation deduction taken over the years.
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Financial Planning Perspectives - This column is produced by the Financial Planning Association, the membership organization for the financial planning community.
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