(This is Part 4 of a five-part series. Read Part 1, "IRS debunks common tax myths"; Part 2, "Homeowners get good tax news for 2007"; Part 3, "How to deduct mortgage interest, points on taxes"; and Part 5, "Understanding Starker exchange rules.")
"The taxpayer: that’s someone who works for the federal government but doesn’t have to take a civil service examination." –Ronald Reagan
Q: How can I make a profit of $500,000 and not have to pay a penny in capital gains tax?
A: Buy a house with your spouse, live in it for at least two years, and file a joint return. Of course, the house has to increase significantly in value.
This is perhaps the most significant tax benefit currently available for homeowners. With the enactment of the Taxpayer Relief Act of l997, signed by President Clinton on Aug. 5, 2007, the two old tax rules relating to home sales — the "roll-over" and the "once in a lifetime" — were abolished.
In order to take advantage of the up-to-$500,000 exclusion of gain (up to $250,000 if you do not file a joint tax return), there are two important tests: ownership and use.
You must have owned and used the home as your principal residence for two out of five years (or a total of 730 days) before the house is sold. The use does not have to be continuous. If, for example, you take a vacation — or are away from the house for short periods of time — this is still counted as "use." However, the longer the absence, the harder it will be to convince the Internal Revenue Service that your use was continuous.
If you are married, in order to take advantage of the up-to-$500,000 exclusion, both husband and wife must meet the use test, although only one spouse must meet the ownership test. 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.
It should be noted that if you obtained title to the house through a "like-kind" (section 1031 Starker) exchange, and subsequently established it as your principal residence, the ownership test increases to five years.
It you are on active military duty or in the foreign service, you can extend the five-year requirement for up to 10 years. Active duty means that you are serving for more than 90 days at a location that is at least 50 miles away from your home.
Unlike the old "once in a lifetime" rule, there is no limit on the number of exclusions you can take, so long as at least two years elapse between each taking.
But what if have to sell and are unable to meet the two-year ownership (and use) requirements? You still may be able to take a reduced exclusion of your gain if you fall into what the IRS calls "safe harbors": a change in employment; health reasons; or unforeseen circumstances. Let’s look at these items separately:
1. Reasons of Health: 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 be entitled to take a partial exclusion. And health is rather broadly defined to include "the diagnosis, cure, mitigation or treatment of disease, illness or injury."
But the IRS wants taxpayers to understand that a sale "that is merely beneficial to the general health or well-being of an individual is not a sale … by reason of health."
2. 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 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 her previous residence. Because the primary reason for the sale was to allow the doctor quicker access to the hospital for emergency purposes, the IRS allowed the partial exemption based on the facts of this case.
3. Unforeseen circumstances: Each of us — at some point in time — will face conditions that could not be anticipated or even imagined before they 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 regulations, which were implemented by the IRS in 2004, 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 lists several safe harbors:
- involuntary conversion of the residence; for example, it was condemned by a governmental agency;
- natural or manmade disasters or acts of war or terrorism resulting in a casualty to the residence. Clearly, people who lost their homes because of the fires last year in California would fall squarely in this category;
- death of one of the owners of the property;
- cessation of employment as a result of which the taxpayer is eligible for unemployment compensation;
- 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.
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."
You will have to convince the IRS that there were valid and compelling reasons that 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 — the amount you can actually exclude depends on how much time you used the house. The formula calls for dividing $250,000 (or $500,000) by 730 days, then multiplying by the days of use. Note that 730 days is two full years.
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.
Now that you understand the exclusion rules, you have to calculate your profit? For many homeowners who bought after 1997, it’s not that difficult. You take your purchase price, add any improvements and closing costs when you bought the property, and deduct this number from the net sales price.
But many homeowners took advantage of the "great American dream," and over the years sold and "bought up." The profit that was made on each sale was deferred under the old roll-over rules.
Let’s take this example: In 1967, you purchased your first house for $50,000. In 1977, you sold it for $160,000, and purchased a new house for $225,000. 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 ($160,000 – $50,000), the tax basis in your new home was $115,000. You determine your basis by subtracting the profit from the purchase price (i.e. $225,000 – $110,000).
In 1989, at the peak of a housing market cycle, you sold your home for $450,000 and purchased a new house for $550,000. Because the roll-over was still the law, you had deferred profit of $335,000 ($450,000 – 115,000). Even though you bought your new home for $550,000, your tax basis was only $215,000. Keep in mind that under the old "roll-over" rules, every new home you purchased had to take into account the deferred gain that 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 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 $715,000 (basis of $215,000 plus $500,000). But, if your spouse has died, and you can no longer file a joint tax return, you can shelter only up to $250,000 of profit. (NOTE: For sales beginning in 2008, under new legislation, a surviving spouse may take the "up-to-$500,000 exclusion provided that the sale occurs no later than two years after the date of the taxpayer’s spouse.)
You or your accountant should make sure that you include the "stepped up" basis of the house in your calculations. This is obviously complicated, (since difference states have different rules) and you must 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. Expenses such as home improvements, real estate commissions, fix-up costs, and 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.
Next week: The Starker, or like-kind, exchange.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to firstname.lastname@example.org.
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