IRS fills in blanks on Capital Gains

Call it a holiday gift for America’s home sellers: The IRS has just answered many of the long-pending questions about tax-free capital gains on home sale profits.

Tops on the list: What happens if you have to sell a house before the minimum two-year threshold for taking the maximum $250,000 or $500,000 tax-free exclusions? The standard rule allows married, joint-filing home sellers who own and use a property as a principal residence for an aggregate two years out of the five years preceding the sale to exclude up to $500,000 in profits, tax-free. Single-filing sellers can shelter up to $250,000 of gain.

But what about people who have to sell before the two-year minimum? For them, Congress created a partial exclusion safety net but limited it to situations in which the early sale was caused by a change in employment, health or “unforeseen circumstances.” The partial exclusion is important because it’s often worth as much as the full exclusion. For example, a single home seller whose employment change forces an early sale after just one year of ownership could qualify for 50% or $125,000 of the maximum $250,000 single-seller exclusion. The odds are that’s more than enough to make the sale totally tax free.

For an employment-related partial exclusion to be allowed, the seller’s new place of work must be at least 50 miles farther from the old (sold) home than the former workplace was from that dwelling.

To qualify for health reasons, early sellers need to show the sale was related to disease, illness/injury of an owner/co-owner of the property, or a physicians recommendations to change residence for health reasons. Sales related to an owner’s need to provide health care for sick family members will also generally qualify, however sales intended to be “merely beneficial to the general health” of the seller will not.

As to “unforeseen circumstances”, the rules identify seven major categories, but open the door to others that the taxpayer can demonstrate fit the letter and spirit of the law. The categories are as follows:

• Death of a homeowner spouse, co-owner or family member.

• Divorce or legal separation of an owner or co-owner.

• A job loss that makes an owner or co-owner eligible for unemployment compensation.

• A change in employment that leaves an owner or co-owner unable to pay the mortgage or basic living expenses.

• Multiple births resulting from the same pregnancy. (Yes, quadruplets can save you taxes).

• Damage to residence caused by natural or man made disaster, acts of terrorism, or war.

• Condemnation of the property by a public entity.

Because of the absence of such rules, in recent years the IRS urged early sellers not to use the “unforeseen circumstances” rational.

Now the agency recommends that anyone who could have qualified for tax relief in a prior year under the newly issued guidelines should seek a refund. File a Form 1040X amendment to whichever year’s tax return on which you initially reported the home sale gain. The new rules clarify other issues, such as what is a principal residence. That is an important definition when many Americans own more than one house but only the principal residence gets the big-dollar capital gains tax breaks. For any given tax year, according to the IRS, your principal residence is the one you use as your home a “majority” of the days during the year.

The rules also list a variety of common-sense indices that help establish your main home address from voter registrations to federal and state tax returns etc.

The IRS’ latest guidance provides surviving spouses the full $500,000 exclusion “only for the year of the decedent spouse’s death.”

For years, armed forces and corporate employees transferred over-seas have complained that their two-and three-year absences from their homes interfere unfairly with their ability to use the $250,000 - $500,000 tax breaks because they are not using their residences.

The IRS declined to change existing rules, suggesting instead that qualified “short-term absences” must be established on individual “facts and circumstances.”

The new rules allow home owners “physically or mentally incapable of self-care” to qualify for the maximum exclusions provided they have lived in their homes for at least 12 months prior to entering a licensed nursing or medical care facility.

By Kenneth R. Harney-Washington –
Reprinted from the Los Angeles Times.

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