Taxes - New IRS Rules on the Home Exclusion

According to the IRS, "A taxpayer who now qualifies for a reduced maximum exclusion and has already reported a gain from the sale of a residence on a prior year's tax return may use Form 1040X to file an amended return claiming the exclusion. Taxpayers may generally amend returns until three years from the original due date. The law did not require taxpayers to meet one of the exceptions before using the reduced maximum exclusion for homes owned on August 5, 1997, and sold within two years after that date.
Thus, nearly all taxpayers qualifying under these regulations should be able to use them by
amending a recent year's return."

In l997, Congress enacted major tax reforms. Perhaps the most significant was the provision that homeowners who lived and owned their home for a period of two years out of five years before the home was sold, were able to completely exclude from gain up to $250,000 if they were single and up to $500,000 for married couples filing a joint tax return for the year of the sale.

More than five years later, on December 23, 2002, the Internal Revenue Service issued two sets of regulations - one final and one temporary - attempting to clarify a number of issues relating to the interpretation of that law.

Final regulations relating to exclusion of gain from sale or exchange of a Principal Residence

What is a Principal Residence?
For taxpayers with multiple homes, the regulations list several factors relevant to determining which home is the principal residence. Among these are amount of time used; place of employment; where other family members live; the address used for tax returns, driver's license, car and voter registration, bills and correspondence; and the location of the taxpayer's banks, religious organizations or recreational clubs.

Vacant land:  The home sale exclusion may include gain from the sale of adjacent vacant land that has been used as part of the residence, if the land sale occurs within two years before or after the sale of the residence.

Occupancy:  Although the regulations do not require continuous occupancy, in order to qualify for the exclusion, the taxpayer must prove that he or she has lived in the property for a full 24 months (or 730 days). Short absences - such as vacation or other seasonal absences - are permitted; a one year sabbatical is not.

Allocation between residential and non-residential : let's take this example. One room in your home is exclusively used for your business operations. You allocate the business use to be one-fifth of your property. Each year, you depreciate a portion of your living expenses on your tax returns. Over the years, you have taken $10,000 of depreciation. You sell your home and have made an overall profit of $50,000. 

If the business use occurred within the same property as the residential use, you must pay tax on the gain equal to the total depreciation you took after May 6, 1997, but may exclude any additional gain on the principal residence up to the maximum amount allowable.  

If the non-residential portion of the property is separate from the principal dwelling - for example a separate garage used for the business - you would have to allocate the gain between the business and the residential, and would only be allowed to exclude the gain on the residential unit.

Unmarried joint owners: For joint owners who are not married, so long as the owners qualify for the exclusion - in other words meet the use and occupancy requirements - each owner can exclude up to $250,000 of gain attributable to their respective interests in the property.  

Ownership by trusts: if the residence is held by a trust, the taxpayer is still considered as owning the property for purposes of complying with the two year use and ownership requirements. For all practical purposes, the IRS will look to the facts and circumstances of the owner - not the trust.

Temporary regulations - involve situations where the taxpayer did not live and use the property for the full two year period.

The tax law provides an exception to the two-year rules for use, ownership and claimed exclusion when the primary reason for the sale is health, change in place of employment, or, to the extent provided in IRS regulations, "unforeseen circumstances." 
 If you qualify under these circumstances, your entitlement would be limited to the percentage of the two years that you fulfilled the requirements. For example, if you owned and occupied your home for one year (half of two years) - and did not exclude gain on another home in that time - you may exclude half the regular maximum amount, or up to $125,000 of gain ($250,000 for most joint returns).

Employment:  To qualify, the new place of employment must be at least 50 miles farther from the old home than the former workplace was from that home. This is the same distance rule that applies for the moving expense deduction.  A qualified person is the taxpayer, the taxpayer's spouse, a co-owner of the home, or a member of the taxpayer's household.

Health:  You could qualify if a physician recommends a change in resident for health reasons related to a disease, illness, or injury of a qualified person.  A qualified person is the taxpayer, the taxpayer's spouse, a co-owner of the home, a member of the taxpayer's household and certain close relatives, so that sales related to caring for sick family members will qualify.

"Unforeseen circumstances":  Includes death; divorce or legal separation; becoming eligible for unemployment compensation; a change in employment that leaves the taxpayer unable to pay the mortgage or reasonable basic living expenses; multiple births resulting from the same pregnancy; damage to the residence resulting from a natural or man-made disaster; or an act of war or terrorism; and condemnation, seizure or other involuntary conversion of the property.
 Any of the first five situations listed must involve the taxpayer, spouse, co-owner, or a member of the taxpayer's household to qualify. The regulations also give the IRS Commissioner the discretion to determine other circumstances as unforeseen.

Remember, according to the IRS..."nearly all taxpayers qualifying under these regulations should be able to use them by amending a recent year's return."
If you believe you might qualify, consult a tax professional.