Principal Residence and Capital Gains Rules

Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate

What's the saying about "death and taxes?" Well, I think it would be appropriate to share some very recent Treasury Department guidance which has the potential of saving you some cash. After nearly many years of uncertainty, the IRS has clarified its rules on capital gains exclusions regarding profits on home sales. Here, in a nutshell, is a description of how the basic capital gains exclusion works and the clarification regarding exceptions. Section 121 of the Internal Revenue Code allows an exclusion of up to $250K of capital gains on a principal residence for single taxpayers and $500K for a married couple filing jointly. To qualify, the taxpayer must own and use the home as a principal residence for an aggregate of 2 of the 5 years prior to the sale. The ownership & use periods do not need to be concurrent; the 2 years may consist of 24 full months or 730 days. Any profits which exceed the exclusion amounts are taxed at the capital gains rate. For taxpayers who sell after ownership of less than 2 years, Congress created a partial exclusion or "safe harbor", when the primary reason for the sale is health, change in place of employment or "unforeseen circumstances". Let´s review briefly each of these possible exceptions:


Exception permitted if the primary reason is related to a disease, illness or injury or if a physician recommends relocation for health reasons. A qualified person for health reasons includes close relatives so that sales related to caring for sick family members will qualify.


Exception permitted if the new job site is at least 50 miles farther from the old home than the old workplace was from that home. This is the same distance rule which applies to the moving expense deduction.

Unforeseen Circumstances

In the absence of formal regulatory guidance from the IRS, many taxpayers have been reluctant to use the partial exclusion. In fact, the IRS had warned taxpayers not to claim "unforeseen circumstances" until the agency had spelled out precisely what circumstances qualify. Now, with these interim rules, the door is open to partial exclusions for tax year 2002 and any prior year´s return where a refund may be available by filing Form 1040X. Here are the 7 major categories which create a "safe harbor", making the claim eligible:
  • Death of the taxpayer, spouse, co-owner or any member of the taxpayer´s household
  • Divorce or legal separation
  • A job loss which results in eligibility for unemployment compensation
  • A change in employment that leaves the taxpayer unable to pay the mortgage or basic living expenses
  • Multiple births from the same pregnancy
  • Damage to the residence resulting from a natural or man-made disaster or an act of war or terrorism
  • Condemnation, seizure or other involuntary conversion
The regulations also give the IRS Commissioner the discretion to determine other circumstances which may qualify as "unforeseen".

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