In last week's article, we pointed out that the IRS has recently clarified many of the cloudy issues surrounding the exclusion of gain on the sale of your home. We discussed the definition of a principal residence and also the rules surrounding partial gain exclusion for health, employment, and unforeseen circumstances.
But those weren't all of the "goodies" for which Uncle Sam provided clarification. But before you begin reading, if you're still unsure of the basics of the exclusion of gain on the sale of your home, make sure to read Home Sale Tax Exclusions: The Basics, and also check out last week's article, Home Sale Rules Clarified.
Gain on sale of vacant land
There have always been questions regarding the sale of vacant land that's adjacent to your personal residence. Is it part of the residence? Is it investment property? And what if the sale of the land occurs at a time different than the sale of the home? These were issues that were never really addressed in the new law, so many tax pros were very surprised when the IRS came out and told us how the process actually works.
The new final regulations state that the home sale gain exclusion applies to the sale of vacant land that is owned and used as a part of your principal residence. This would preclude land that you might be using for farming or other business use. It would simply imply a land area adjacent to the home where the kids play and Rover chases balls. Or it could be a place where the weeds grow. The important issue is that this property must not be used for business purposes.
Additionally, the sale of the home must occur within two years before or after the sale of the related vacant land in order for both the home and the land to both qualify under the $250,000/$500,000 exclusion. Don't think that because you might have two sales that you'll qualify for two exclusions; it doesn't work like that. Instead, the total exclusion amount will be applied to both sales.
Example: Consider my married friends Mary and Phil. They own a home and also a big lot adjacent to the home. The lot is really a separate piece of property on the assessor's map, but that's immaterial in this case. The law doesn't make a distinction if the property has separate lot lines and is another piece of subdivided property -- only that it's adjacent to the home property.
Mary and Phil decide to sell their home (just the home, not the adjacent lot) in a "qualifying sale" (i.e., the ownership, use, and time tests have all been met to allow for the exclusion of the gain) and have a gain of $150,000 on that sale. Eight months later, they sell the vacant lot next door for a gain of another $75,000. Since the combined gain on the sale and the lot ($225,000) is less than their allowed exclusion of $500,000, they can exclude the gain from both sales. If the gain on both sales had been greater than the $500,000 maximum exclusion, there would be taxes to pay.
Sales in different years: If the sales of the home and the adjacent land take place in different tax years, you'll take your exclusion in tax year #1 for the appropriate sale. Then, in tax year #2, when the sale of the other property is closed, you'll be required to go back to your tax year #1 tax return and file an amended return (Form 1040X) in order to combine the sale of the properties and claim the maximum exclusion. So while it might be a bit of a hassle, the tax dollars saved will be well worth the effort.
But remember that in order to receive the gain exclusion on both properties, and for both sales to essentially be treated as one, the home must be sold within two years before or after the sale of the vacant land.
Big guys qualify also: There may be many of you who are sitting on a very large parcel of property adjacent to your home, perhaps many acres. And that property would also qualify. It's not only for the small (or large) vacant lot adjacent to your home. It covers virtually any non-business use property adjacent to the home.
In fact, the regulations provide an example where a taxpayer separately sold a 29-acre parcel of raw land adjacent to a one-acre parcel that contained his home. The combined gains for both the home and 29 acres were treated as a single gain eligible for the entire gain exclusion. It doesn't get much better than that!
Home used for business or rental
This another area that has been troublesome issue since the new laws were initially passed. Proposed regulations issued in 2000 were very strict on how the "business" portion of a home would be taxed and how it would be subject to tax. But thankfully, the new final regulations adopt a much more liberal interpretation for homes that are used both for personal and business use (called "mixed-use" property).
The new rules say that you don't have to allocate a gain to both the home property (non-taxable) and business property (taxable) as long as both the home and business portions are within the same dwelling unit. In other words, the entire property can qualify for the gain exclusion, provided all of the other qualification rules (ownership, use, time) are met. This is extremely good news for those of you who have been claiming the office-in-home deduction, or perhaps rent out part of your home or use it partially for other business reasons.
But along with the good news comes a little bad news. Any depreciation taken on the business use of the property after May 6, 1997, can not be excluded under the home sale rules. This isn't any different from the rules we've been living with, so it's not a surprise. But you should also know that if the business and non-business portions are in separate dwelling units on the same piece of land, the allocation of the gain must take place, and taxes must be paid on the business portion of the gain.
Example: The final regulations tell us about Fred, who used part of his home as an office to conduct his law practice. He claimed $20,000 of post-5/6/97 depreciation on the office in his home. Fred then sold the home for a qualifying gain of $150,000. All of his gain is excluded except for the depreciation that took place after 5/6/97 -- $20,000 in our example. So Fred is allowed to exclude $130,000 of the gain entirely, but will be required to report gain of $20,000 on the depreciation recapture, and pay taxes at a maximum rate of 25% on this gain.
The final regulations provide another example, assuming the same facts as above except that Fred's office was situated in a converted, detached garage building. In this situation, the sale of the property must be treated as two separate sales: one for the sale of the home and one for the sale of the business use property. The gain on the sale of the home can be excluded, but the gain on the sale of the detached business property must be computed and will be subject to tax.
It's easy to see how these new final regulations will provide for some sweet opportunities to reduce your taxes. The new rules are effective for sales after Dec. 23, 2002. But for those of you who sold a principal residence between May 6, 1997, and Dec. 24, 2002, you can elect to have these new rules apply retroactively for sales that took place for any "open" tax year.
So if you sold a home recently and used prior IRS guidance (either virtually no guidance or the 2000 proposed regulations), there could be an amended return in your future. If you claimed a taxable gain because of business use, or a change in employment, or unforeseen circumstances, or the sale of vacant property adjacent to the home, and the new final regulations allow for that gain to now be excluded, then you'll want to file an amended return for the appropriate sale year and get some of that money back that Uncle Sam removed from your wallet.
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.