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IRS offers leeway on tax-free capital gain from a sale

By Robert J. Bruss, Special to The Times

In 2003, the IRS issued new liberalized rules interpreting the law that allows tax-free capital gain on the sale of a principal residence, and a federal court issued the first ruling interpreting Internal Revenue Code 121. Before getting to these developments, here's a basic review.

IRC 121, enacted by Congress in 1997, offers up to a $250,000 principal-residence tax exemption for an individual and up to $500,000 for a married couple filing jointly.

To qualify, the sellers must have owned and occupied their principal residence an "aggregate" two of the five years before the sale. Occupancy need not be continuous, nor must the residence be the seller's principal residence at the time of sale.

For example, if the seller owned and occupied the home for two years, and then rented it to tenants up to three years, the sale qualifies. The exemption can be used repeatedly, but not more than once every 24 months.

The method of holding title is not important. For a married couple to claim up to $500,000 tax free, only one spouse's name need be on the principal residence title, providing both meet the occupancy test. Or, if title is held in a living trust, new IRS regulations clarify that the full tax exemption is still available.

Gone are the pre-1997 principal-residence tax rules involving the need to buy a replacement home and the once-in-a-lifetime "over 55" age restrictions.

Here are updates on rules regarding IRC 121:

  Tests for determining your principal residence.

In 2003, a U.S. District Court decided a case brought by retirees James and Jean Guinan, who owned and lived in homes in Wisconsin and Arizona. When they sold the Wisconsin property, they met the two-out-of-five-year ownership and occupancy tests for that home. In addition, they met some of the IRS principal residence regulation tests such as having Wisconsin auto registration and bank accounts.

But the court noted that the Guinans lacked Wisconsin voter registration, local civic contacts, employment and had never filed Wisconsin income-tax returns. The court ruled there was insufficient evidence to prove "relevant factors," so the Guinans owed $45,009 capital gain tax on the sale of the Wisconsin home (Guinan vs. U.S., 2003-1 USTC 50475).

  Partial exemption after less than two years ownership and occupancy.

Last year the IRS issued new regulations that can be used retroactively for transactions that are still "open" for income tax returns. Currently those include returns for 2003, 2002, 2001 and 2000. A partial $250,000 exemption is available for homes sold within less than 24 months of ownership and occupancy if the reason for the sale is (a) change of employment location, which qualifies for the moving-cost tax deduction, (b) health reasons for illness treatment or to care for a family member, and (c) unforeseen circumstances, including death, divorce, unemployment, change of employment, which leave the taxpayer unable to pay the mortgage or basic living expenses as well as multiple births from the same pregnancy, damage to the residence, condemnation and involuntary conversion of the property.

Partial exemptions are available for these situations based on the percentage of the 24-month occupancy time. For example, a principal residence occupied for 18 of the required 24 months, would entitle the owner to 75% of the $250,000 or $500,000 (if married) exemption.

  Special rule for divorced and separated couples.

Inter-spousal real estate transfers, during the marriage or as part of a divorce or legal separation, are tax free under Internal Revenue Code 1041. If the couple retains co-ownership, but just one ex-spouse remains living in the principal residence while the other ex-spouse lives elsewhere, each spouse can claim up to $250,000 tax-free sales profits if the spouse living in the home meets the two-out-of-five-years occupancy test when the home is sold.

In other words, if the "in spouse" living in the principal residence qualifies for the IRC 121 $250,000 exemption, the "out spouse" not living in the residence also qualifies for up to $250,000 tax-free capital gain when the home is sold.

  New rule for sale of vacant land adjoining a principal residence.

Even if the home isn't sold at the same time, the land sale can now qualify for the $250,000 or $500,000 exemption if the adjacent parcel is sold within 24 months before or after the principal residence sale.

  The surviving spouse rule is unchanged.

If a home is sold in the year of a spouse's death, the surviving spouse can claim up to $500,000 tax-free profits. However, if the home is sold after the year of the death, the exemption reverts to $250,000.

This rule doesn't force surviving spouses to sell their homes promptly to claim the $500,000 tax exemption because they usually receive a new "stepped-up basis" for the home as of the date of the spouse's death.

In a community property state such as California, the surviving spouse's new basis is usually stepped up to 100% of market value on the date of death. The result is that little or no tax is due if the home is sold within a few years after the first spouse's death.

  Partial interest sales qualify for the tax exemption.

When a principal residence co-owner sells all or part of his or her interest in the home, that sale can qualify for the $250,000 exemption. But if the co-owner sells less than his or her full interest, this does not create a new loophole because the regulations allow only a total exemption up to $250,000.

  A vacation or limited-use second home is not a principal residence so its sale does not qualify for the IRC 121 tax break.

The best way to avoid taxes on the sale of a vacation or second home is to convert it to a rental property and then make a tax-deferred exchange using Internal Revenue Code 1031(a)(3) for another qualifying investment or business property.

Careful advance tax planning often is required to take advantage of the principal residence exemption. Consult your personal tax advisor.

Next week : How to deduct home-business expenses.


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