The Home Sale Exclusion and current events
By Zev Landau
Tax rules react to what happens in society, and the principal residence exclusion is an example. The September 11, 2001, terrorist attacks, the war in Iraq, high unemployment, and the changing economic climate are all reasons to be more familiar with the circumstances that allow the exclusion of a large amount of gain when taxpayers sell their principal residence.
On October 10, 2002, the Wall Street Journal advised homeowners: “If you are considering selling your house, sooner rather than later might be the way to go. Home prices have increased at least twice as fast as household income in more than 100 U.S. cities since 1998 … then and now, many economists fret certain areas could be poised for a tumble.” On April 1, 2003, the Wall Street Journal wrote about “Making the Transition Back to Local Work after an Overseas Job.” The uncertain employment and international environments explain why IRC section 121, addressed by this article, is more important than ever.
Since May 7, 1997, the home sale exclusion is no longer a once-in-a-lifetime exclusion; it can be repeated in future sales (but as a general rule, home sellers must wait two years before being eligible to exclude any gain on the next sale of another principal residence). Under the old law, if home sellers that were 55 or older wanted to defer gain (which was not the same as excluding it permanently), they were required to purchase a new and more expensive residence by reinvesting the proceeds from the sale of their old residence. If the new residence was less expensive, they could defer part of the gain.
Under the new law, a taxpayer’s age is no longer a factor, taxpayers do not have to purchase a replacement residence, and the exclusion is much larger. Single taxpayers and married taxpayers filing separately can exclude up to $250,000. For spouses filing jointly, the exclusion can be up to $500,000.
The Three Tests
If a taxpayer wishes to be eligible for the maximum $250,000 gain exclusion, there are three important tests homesellers must pass: ownership, use, and prior exclusions. There are three questions to be asked:
If the taxpayer passes all three tests, she is eligible for the exclusion. The same tests apply to spouses that file joint returns with a maximum exclusion doubled to $500,000. The double exclusion is available if:
The Circumstantial Exceptions
If the two-out-of-five-years ownership and use requirements are not satisfied, any realized gain on the sale or exchange must be recognized. In addition, if there was any other applicable sale or exchange by the taxpayer during the two-year period ending on the date of the sale or exchange, no exclusion is allowed.
But there are exceptions. According to the American Bar Association (ABA):
Where the home is sold after less than two years of ownership, there is usually an unexpected reason for the sale. In such situations, the owner is often unlikely to generate a gain from the sale due to the short ownership period and the costs of selling the home. However, in certain real estate markets, a gain may result. In light of the otherwise ameliorative nature of IRC section 121, requiring an individual to pay capital gain taxes on top of the other costs of selling, moving, and dealing with the personal issues that compelled the sale of the home would seem to deviate from congressional intent. Thus, in drafting guidance on ‘unforeseen circumstances,’ a broad view should be taken of the personal circumstances that may unexpectedly require an individual to sell a home owned for less than two years. [As reported in the Real Estate Journal (October 3, 2001).]
When it issued the proposed regulations, the IRS requested guidance concerning what types of “unforeseen circumstances” would justify a reduced exclusion. Potential unforeseen circumstances identified by commentators such as the AICPA included: financial hardship, such as when an individual loses his job or is required to take a substantial cut in pay or faces increased living expenses; the loss of income of a family member who pays the costs of maintaining the home; divorce, separation, or breakup of a long-term nonmarital relationship; death of a co-owner or co-occupant of a home; a health change of a nonowner of a home or a family member not in the household; and changes in usability of a home due to environmental concerns.
On December 24, 2002, the IRS issued new temporary and proposed regulations on the reduced exclusion of gain when taxpayers fail to qualify for the full exclusion because they did not meet the three aforementioned tests.
The taxpayer’s primary reason for the sale or exchange is determined based on the facts and circumstances. The temporary regulations provide a list of factors that may be relevant in determining the taxpayer’s primary reason. These factors are suggestive only. No single fact or particular combination of facts is determinative of the taxpayer’s entitlement to the reduced maximum exclusion.
In addition, for each of the three grounds that allow taxpayers to claim a reduced maximum exclusion amount (change in taxpayer’s place of employment, health, or unforeseen circumstances), the temporary regulations provide a general definition and certain safe harbors. If a safe harbor applies, the taxpayer’s primary reason for the sale or exchange is deemed to be a change in place of employment, health, or unforeseen circumstances. The temporary regulations provide that the primary reason for the sale is deemed to be a change in place of employment, if the new place of employment of a qualified individual is at least 50 miles farther from the residence sold or exchanged than was the former place of employment. If the individual was unemployed, the distance between the new place of employment and the residence sold or exchanged must be at least 50 miles.
If the any of the three exceptions apply, the maximum exclusion of $250,000/ $500,000 is no longer available. Instead, the maximum exclusion is prorated to a fraction. The numerator is the smallest of the following period of time:
The denominator is equal to the required period of ownership and use (i.e., either two years, 24 months, or 730 days).
Example 1. Twelve months after purchasing a principal residence, Jane Smith sells the house due to a change in her employment. She did not exclude gain on a prior sale or exchange of property during the two years prior to the sale. Jane is eligible to exclude up to $125,000 of the gain from the sale of her house (12 months/24 months x $250,000).
Example 2. Bill Jones owned and used his principal residence since 1996. On January 15, 1999, he got married and his spouse Mary began to use the house as her principal residence. On January 15, 2000, Bill sold the house due to a change in the couple’s employment. Neither he nor his spouse excluded gain on a prior sale or exchange of property between January 16, 1998, and January 15, 2000.
The Joneses filed a joint tax return, but must separately calculate the maximum allowable exclusion because Bill owned and used the principal residence for the entire period preceding the date of sale. Therefore, Bill’s share in the exclusion is $250,000, because the ownership and use period exceeded two years and it was his first sale of a principal residence; thus the requirement of one exclusion does not apply to him.
Between January 16, 1995, and January 15, 2000, Mary did not own the house, but this does not matter because only one spouse is required to own the house for two years. Mary moved because of a change in job location. She used the house for only 12 months (from January 16, 1999, to January 15, 2000). Therefore, the spouse’s share in the exclusion has to be prorated and is equal to $125,000 (12 months/24 months x $250,000). The combined maximum exclusion is $375,000, instead of $500,000.
The Impact of the September 11, 2001, Terrorist Attacks
A taxpayer who fails to meet any of the three tests by reason of a change in place of employment, health, or unforeseen circumstances, is entitled to an exclusion in a reduced maximum amount.
But what is the meaning of the term “unforeseen circumstance” in the context of the September 11, 2001, terrorist attacks? A definition is found in IRS Notice 2002-60:
Recently, the IRS has been asked whether taxpayers affected by the September 11, 2001, terrorist attacks are entitled to exclude the gain from the sale of a principal residence in a reduced maximum amount by reason of unforeseen circumstances. In response, the Commissioner has determined that taxpayers affected by the September 11, 2001, terrorist attacks are entitled to the reduced maximum exclusion. Therefore, a taxpayer may claim a reduced maximum exclusion of gain on a sale or exchange of the taxpayer’s principal residence by reason of unforeseen circumstances if the taxpayer sells or exchanges the residence as a result of being affected by the attacks in one or more of the following ways:
1) A qualified individual (as defined below) was killed,
2) The taxpayer’s principal residence was damaged …
3) A qualified individual (as defined below) lost employment and became eligible for unemployment compensation …
4) A qualified individual (as defined below) experienced a change in employment or self-employment that resulted in the taxpayer’s inability to pay reasonable basic living expenses for the taxpayer’s household (including amounts for food, clothing, housing, and related expenses, medical expenses, taxes, transportation, court-ordered payments, and expenses reasonably necessary to production of income, but not for the maintenance of an affluent or luxurious standard of living). …
[T]he term “qualified individual” means, as of September 11, 2001, the taxpayer, the taxpayer’s spouse, a co-owner of the residence, or a person whose principal place of abode is in the same household as the taxpayer.
According to the October 3, 2001, Real Estate Journal:
Section 121’s tests have become relevant to all those troops that participate in the war against terror. The ABA suggested to incorporate into the proposed regulations a modification that would suspend, for time spent away from home due to official extended duty, the five-year period during which the ownership and use requirements of section 121 must be met. … As an alternative, if the IRS believes that the preceding recommendation cannot be accomplished without legislative action, the ABA comments recommend that the section 121 regulations address this issue through the definition of a temporary absence. The definition of temporary absence in Proposed Regulations section 1.121-1(c) could be expanded to provide that, for members of the military, time spent away from a residence on government orders will count as use of the residence. A minimum actual use requirement could be added to ensure that the owner’s intent was to use the residence as a personal residence. For example, the member of the military could be required to have a minimum of three months of actual use as a residence in order to treat time spent away on assignment as use of the residence.
William Bregman, CFP, CPA/PFS
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