The Taxpayer Relief Act of 1997 turned the home sale gain rules on its head. Under the new law, generally effective for property sales after May 6, 1997, up to $250,000 of the gain from the sale of a single person's principal residence is tax-free. That's right -- tax-free. And, for certain married couples filing a joint tax return, the amount of tax-free gain doubles to $500,000.
Gone were the old rules where you could "buy up" and avoid current taxes on the sale of a principal residence. Gone also was the "once in a lifetime" gain exclusion provisions.
However, there were many questions in the original law that were difficult to resolve without additional help from Uncle Sam. Well, the final regulations on these issues have recently been issued. Surprising to many tax pros, these final regulations are liberal. Not only that, the new rules can be applied retroactively to any prior sales that have occurred.
The "retroactivity" of these new regulations can be very good news for taxpayers who sold their homes in the recent past and were a bit unsure of the applicable tax treatment and how the IRS might apply the previously unwritten rules. Well, now we know. And this is a very big deal!
Definition of principal residence
One of the most perplexing issues in the new law was the definition of a principal residence. Under the old law, many issues dealing with the definition of a principal residence had been ruled on by the courts. But many tax pros were unsure if those definitions would also apply to the new law. If you have multiple homes, and spend considerable time in each, this becomes an extremely important issue.
The IRS says that, generally, your principal residence will be the home where you spend the majority of your time. But this isn't the only test. Other factors that will be relevant to the determination include but are not limited to:
- Your place of employment
- Where your family lives
- The address you use on your tax return
- The address you use for your general mail, bills, bank statements, and brokerage statements
- Where you maintain your bank accounts and banking relationships
- Where you maintain your memberships (such as country clubs, health clubs, etc.) and religious affiliations
Not stated in the regulations but important to the determination of your principal residence are:
- Where you are registered to vote
- The address on your driver's license
- The property on which you claim your homeowners property tax exemption (many states and counties allow for the payment of lower property taxes on your principal residence)
None of these issues will provide a clear definition of your principal residence. As noted in the regulations, all of the facts and circumstances will be considered. If you have a second, third, or even a vacation home that you are considering selling and would like to avail yourself of the gain exclusion rules, make sure that it'll qualify as your personal residence taking into consideration all of the issues noted above.
As noted in my article Home Sale Tax Exclusions: Special Rules for Married Folks, there are special rules that come into play to allow for at least a partial exclusion of the gain on the sale even if you didn't live in the property for the required two-year period. The law stated that if the move was due to (1) a change of your place of employment, or (2) health, or (3) unforeseen circumstances, a partial exclusion would be allowed. Sadly, the IRS was silent on the definition of these provisions... until recently.
Change in place of employment: The IRS says that this is a change of employment or self-employment for any of the following people (a "qualified individual"):
- Your spouse
- A co-owner of the property in question (such as a live-in partner with an ownership interest in the property)
- A person whose principal place of abode is in your home
But a simple change of employment across town won't be enough to trigger the partial-gain exclusion. The new place of employment for the qualifying individual must be at least 50 miles farther away from the residence being sold than was the former place of employment. If there was no former place of employment (such as the beginning of a new venture or following a term of unemployment), the distance between the new place of employment and the residence being sold must be at least 50 miles. In effect, these are the same distance rules that apply for the deduction of moving expenses.
But even if the distance test isn't met, don't give up hope. The reduced exclusion is still allowed if the facts and circumstances indicate that the home sale was primarily due to a change in the place of employment, and the IRS provides two examples in the regulations (see Temp. Reg. 1.121-3T).
Health reasons: The IRS says that a sale is primarily for health reasons when the facts and circumstances indicate that the move is specifically related to a disease, illness, or injury of a qualified person. For this section, a qualified individual includes not only those mentioned above but also:
- A person who is related to any of the "qualified individuals," either by blood or marriage, or
- A descendant of your grandparent (such as your first cousin)
I'll not bore you with all of the official language. Suffice it to say that this is a really broad definition of who is "related" to you, and would include virtually anybody that you would consider related in the true sense of the word. But if you are moving because of the health issues of the third cousin of your father-in-law from your second marriage, you'll want to check out the actual definitions just to make sure that you qualify for the reduced exclusion.
And, as always, a move that is simply and only beneficial to the general health or well-being of any of these individuals will not be considered primarily for health reasons. Moving to Arizona to "feel better" in the warm winter environs just isn't enough to qualify for the exclusion.
Unforeseen circumstances: The actual law on this issue basically states that there are no unforeseen circumstances until and unless they are defined in the regulations. This has been a touchy issue because until this time, the IRS hadn't provided guidance as to what would constitute such a circumstance. Well, they're here now, and better than some had hoped for.
The IRS says that you'll have unforeseen circumstances (and therefore be eligible for the partial-gain exclusion) if any of the following events occur to the qualifying individual during the ownership and use of the property as principal residence:
- Involuntary conversion of the home
- Natural or man-made disaster or act of war or terrorism resulting in a casualty to the home
- Cessation of employment, making him/her eligible for unemployment compensation
- Change in employment or self-employment that results in the inability to pay housing costs and basic living expenses
- Divorce or legal separation under a decree of divorce or separate maintenance
- Multiple births resulting from the same pregnancy
None of these apply to you? Don't worry. The IRS says that you can still qualify for the reduced-gain exclusion if the facts and circumstances indicate that the primary reason for the home sale is due to the occurrence of an event that you didn't anticipate before purchasing and occupying the property.
The regulations again provide two examples of these situations, which seem to indicate that the IRS will be fairly liberal in their interpretation of the rules. So again, if you were required to sell your property before the two-year period had lapsed, and none of the above specific circumstances applies in your case, make sure that you (or your tax pro) have reviewed the regulations to see if Uncle Sam might consider your specific issues "unforeseen circumstances."
There are other issues that were clarified by the IRS with respect to the home sale gain exclusion, and we'll discuss them next week.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.