As we noted, to claim the exclusion for the gain on the sale of your home you must have used the home as your principal residence for a period of two years or more in the five-year period ending on the date you sell the home.
The IRS says that you will meet the test if you can show that you owned and lived in the property as your principal residence, or main home, for either 24 full months or 730 days during the 5-year period ending on the date of the sale. And, while short, temporary absences for vacations and other seasonal absences will count as periods of use, converting the property into a rental unit if you move to another primary home may jeopardize your use of the exclusion.
Example #1: On July 1, 1997, Barbara bought a condo for $125,000 and moved into it as her principal residence. Barbara usually spends 3 or 4 months in Europe each year, enjoying both the beer gardens and castles of Germany. But, in May 2000, Barbara's health took a turn for the worse, and she decided to move into an assisted living facility. On December 10, 2001, while still residing in the assisted living facility, Barbara sold her home for $195,000. Barbara can exclude the $70,000 gain on the sale of her principal residence because she met the ownership and use tests.
Barbara's 5-year period is from December 9, 1996, to December 10, 2001, (the date that she sold the property). (Note that, for the 5-year period, it doesn't matter that she didn't own the property until July 1997, because the rules state that she just has to own and use the condo as her principal residence for any two out of the past 5 years, which she did. She could have purchased the condo as late as December 9, 1999 to meet this requirement, in fact.)
She owned the condo from July of 1997 to December of 2001, which is certainly more than two years. In addition, she lived in the condo from July of 1997 to May of 2000, which is also more than two years. Since Barbara met both of the ownership and use tests, Barbara will qualify for the exclusion. Barbara's annual trips to Europe do not reduce her use of the property as her principal residence because temporary absences, such as for vacations, do not reduce the months of use of the property.
Well, what happens if you are unable to meet the "own and use" restrictions. Does that mean you lose the entire exclusion? Nope. Not at all. If you can't meet the restrictions, you might still be able to exclude part or all of your home sale gain if either of the following conditions exist:
1. You owned your residence on August 5, 1997, and sold it after that date but before August 5, 1999. Your reason for selling the residence is immaterial.
2. You fail to meet the "own and use" qualification and/or the "only once every two years" qualification because you had to sell the home due to a change of your place of employment, health, or because of other unforeseen circumstances.
Example #2: Jerry bought his home in January 2000. In September 2001 Jerry sold his home because he was relocated to another state by his company. Even though Jerry didn't meet the "own and use" tests, he was still able to exclude part or all of his gain because exception 2 above was met (he had to sell his home because his employer changed his place of employment).
Computing the Reduced Exclusion
We now know that Tom and Jerry may qualify for a reduced exclusion. Now we need to know how much the exclusion is reduced. The IRS says that we need to follow a four-step process:
Did you find it a little odd that these examples had to do with single people? As well you should, since the rules are a bit different for married folks. We'll look at those differences in the final installment of the home sale rules.