Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate
Based upon the enormous number of questions I receive
regarding the current IRS rules on tax-free home sales, I think it is time to address the confusion that exists and to clarify the rules on capital gains exclusions. The cange to the law is VERY significant and can result in HUGE tax savings for folks who either have or are contemplating a sale.
I think that the confusion most folks have stems from the rules which were in effect up until May 1997. Until then, homeowners could defer profit on the sale of their principal residences, no matter how long they owned the home, so long as they purchased replacement homes of equal or greater value. Then, once they were finished with principal residence purchases, they were eligible for an age 55 lifetime capital gains exclusion of $150,000 on all of their principal residence sales. If your total net gain exceeded the exclusion, you paid federal and state capital gains tax on the excess profit.
The Taxpayer Relief Act of 1997, specifically Section 121 of the Internal Revenue Code, changed all of that! Now, single homeowners get to exclude from income up to $250,000 of gain and married couples, up to $500,000. Co-owners may each claim a $250,000 exemption. One provision is that the home must have been your principal residence and that the taxpayer(s) must have used the home as such for an aggregate of at least two of the last five years prior to sale. The two years do not have to be consecutive. And, what makes this change doubly "sweet" is that this tax break can be used over and over again... but not more frequently than once every 24 months! In addition, there is no requirement that you purchase a replacement home. In essence, this change is HUGE... the savings in taxes when you sell each property and over your lifetime can be enormous. This is especially true here in the San Diego area
where it is most common to see gains on a single home sale which greatly exceed the previous lifetime exclusion of $150,000!
Ok, does that mean "sell too soon and miss the exemption"? What about those poor folks who sell after ownership or occupancy of less than 2 years? Do they get a partial break? Well, "maybe". Congress did provide for some limited exceptions, or "safe harbors", for home sales after less than 2 years of ownership and occupancy if the homeowner had to move due to specified reasons. Generally, the primary reason for the sale must be for reasons of health, employment change or "unforeseen circumstances". For those who qualify, a "reduced maximum", partial capital gains tax exclusion is available, based on the amount of time they owned and used the home.
Exceptions for health reasons require that the "primary reason" for the sale must be "to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury" of the homeowner, co-owner, spouse or other domiciled resident. If homeowners sell early just because they think they might feel better living somewhere else, the IRS is not likely to be sympathetic. And, a sale for a move "that is merely beneficial to the general health or well-being of an individual" will not qualify for the tax break.
Employment change exemptions may be 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 essentially the same distance rule that applies to the moving expense deduction.
So, exceptions for health or employment are quite easily explained. But, what about these "unforeseen circumstances"? The IRS´ new rules provide some no-nonsense answers. First, homeowners cannot claim that they experienced an "unforeseen" overwhelming desire to own a different house in a different neighborhood and expect to get an exception to the two year rule on ownership and use. Ditto for winning the lottery. Just because a homeowner is suddenly flush with cash and has a wider range of houses to choose from will not be enough to qualify for an "unforeseen" exception to the standard set by the law. The same goes for sudden marriages which some taxpayers have argued truly fall into the category of "unforeseen" events.
What does qualify as unforeseen, according to the new rules, are events "that the taxpayer could not reasonably have anticipated". These situations include:
- The "involuntary conversion" of a home... for instance, when the state government requires an owner to sell to make way for a new highway (typically called "eminent domain")
- Natural or man-made disasters or acts of war or terrorism that damage the residence
- The death of the homeowner, a spouse, co-owner or other person whose principal place of residence is the house that was sold
- A loss of employment triggering eligibility for unemployment compensation.
- A change in employment status that results in the owner´s inability to pay housing costs and reasonable basic living expenses for the household
- Divorce or legal separation
- Multiple births resulting from the same pregnancy
That pretty much exhausts the IRS´s qualifying list of "unforeseen" precipitating events for a home sale. However, the final rules do allow taxpayers to make their case on a "facts and circumstances" basis.
The rules also incorporate important changes to the home-sale capital gains law mandated by the Military Family Tax Relief Act of 2003. Members of the armed forces
or the foreign service who are posted abroad for extended periods now will be permitted to stop the two-out-of-five-year clock when they leave the country. That, in turn, should help avoid situations where military and foreign service personnel confront big tax bills on home sales because they were not occupants for long enough periods during the preceding five years.