IRS Issues Final Regulations On Home Sales
The IRS has issued final regulations regarding the tax treatment when a taxpayer sells the principal residence less than two years after it was purchased.
After many long years of waiting, the Internal Revenue Service has issued final regulations regarding the tax treatment when a taxpayer sells the principal residence less than two years after it was purchased.
These new rules have significant impact, insofar as many homeowners have made fantastic profits in the past few years, but find that -- for many reasons -- they have to sell their house before they have owned it for a period of two years.
Why is this important? If you sell your house and have owned and used it for two years out of a period of five years before it is sold, you have the absolute right to exclude up to $250,000 of the profit you have made from the sale. If you are married -- and file a joint tax return -- you can exclude up to $500,000 of your profit.
However, if you have not owned and used your home for this two-year period, depending on the circumstances surrounding the sale, you may have to pay the full tax on your profit -- either at ordinary income rates or capital gains rates, depending on how long you have owned the property.
When Congress authorized these large exclusions back in 1997, it opened the door for reduced exclusions under certain limited circumstances. Section 121(c) of the Internal Revenue Code specifically provides that even if a taxpayer did not own and use the house for the full two-year period, if the house has to be sold for reasons of (1) a change in place of employment, (2) health or (3) unforeseen circumstances as provided and defined in IRS regulations, the taxpayer may nevertheless be entitled to a partial exclusion of the gain.
The new regulations are required by law, in order to spell out a definition of "unforeseen circumstances" and give guidance to both the taxpayer as well as the IRS. The regulations also provide what the IRS calls "safe harbors" -- i.e. if you fall into a safe harbor category, you are entitled to take the partial exclusion. If, on the other hand, you are not within the safe harbor, then according to the regulations "the taxpayer may be eligible to claim a reduced maximum exclusion if the taxpayer establishes, based on the facts and circumstances, that the taxpayer's primary reason for the sale ... is a change in place of employment, health or unforeseen circumstances."
In other words, if you are not within a safe harbor, you will have to convince the IRS that you nevertheless qualify for the partial exemption.
Let's look at these items separately:
It is interesting to note that the IRS has given a broad definition to the concept of "qualified individuals." Such persons include the taxpayer, the spouse of the taxpayer, a co-owner of the residence and even a "person whose principal place of abode is in the same household as the taxpayer."
Why such a broad coverage? According to the IRS:
If you are eligible for the partial exclusion -- either because you meet the safe harbor tests or the facts and circumstances test -- this exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is two full years. If you are single -- or do not file a joint tax return -- change the $500,000 to $250,000.
If real estate sales start slowing down, and profits start dropping, these new regulations may be completely academic. However, if you find that you have to sell your house before you have owned and used it for two full years, and if (as have many people) you will make a significant profit, it clearly is important to try to qualify for the partial exemption.
If you are in doubt, try
to hang on to your house until you meet the two-year test. You may find that
with a little effort, you can save a lot of tax dollars.