The Internal Revenue Service has issued final regulations on the exclusion allowed for gain on the sale of a principal residence. The final regs modify the rules contained in temporary regulations with respect to partial home-sale exclusions. They also provide special rules for military and foreign-service personnel.
An individual can exclude from gross income up to $250,000 of the gain from the sale or exchange of a home that he owned and used as a principal residence for at least two of the five years before the sale or exchange. However, the exclusion isn’t available if there was another sale of a principal residence by the taxpayer to which the exclusion applied within the two-year period ending on the date of the exchange.
Married taxpayers filing jointly for the year of sale may exclude up to $500,000 of gain from the sale of a principal residence if:
- Either spouse owned the property for at least two of the five years before the sale or exchange;
- Both used the property as a principal residence for at least two of the five years before the sale or exchange; and,
- Neither spouse sold a principal residence to which the exclusion applied during the two-year period ending on the date of the sale or exchange.
Applying a partial exclusion
A partial homesale exclusion may apply to a taxpayer who fails to qualify for the two-out-of-five-year ownership and use rule, or who previously sold another home within the two-year period ending on the date of the sale or exchange of the current principal residence. If the failure to meet either rule results from the home being sold or exchanged due to a change of place of employment, reasons of health, or, to the extent provided in regulations, other unforeseen circumstances, a partial exclusion may be allowed.If one of these conditions is present, gain can be excluded in an amount equal to the full exclusion (either $250,000 or $500,000, as the case may be) times a fraction. The numerator of the fraction is the shorter of the aggregate periods of ownership and use of the property by the taxpayer as a principal residence during the five years ending on the sale or exchange date, or the period of time after the last sale to which the exclusion applied, and before the date of the current sale. The denominator of the fraction is two years (or its equivalent in months or days).
Observation: In effect, what is reduced is the maximum amount that can be excluded. Unless there has been a large increase in the value of the property between the date that it was bought and the date that it was sold, the seller usually will be able to exclude her entire gain from the sale. In most cases, less than all the gain will be excluded only on the sale of very expensive residences.
Example 1: Your client, a single taxpayer, bought a new house on July 1, 2003, for $800,000. She used the house as her principal residence during the entire period that she owned it.
On July 1, 2004, because of a change in her place of employment, she sold the house and had a gain of $100,000 on the sale. She qualifies for a maximum exclusion of $125,000 (one-half of $250,000, since she owned and used the house as her principal residence for one year, or half of the two-year period that she would have had to own and use it to qualify for the full $250,000 exclusion). Since her gain of $100,000 was less than the reduced maximum exclusion that she was entitled to, she can exclude her entire gain.
Under temporary and proposed regulations issued last year, the service adopted a position with respect to the partial exclusion that was generally favorable to taxpayers. The final regulations follow the approach of the temporary and proposed regulations with the following changes.
The temporary regulations generally provided that a sale is because of a change in place of employment, reasons of health, or unforeseen circumstances only if the taxpayer’s primary reason for selling is one of the three statutory reasons. They gave a general definition for each of the three statutory reasons, and provided one or more safe harbors for each. If a safe harbor applied, the taxpayer’s primary reason for the sale was deemed to be a change in place of employment, health, or unforeseen circumstances.
The final regulations delete the primary reason test from the safe harbors and provide that, if a safe harbor applies, the sale or exchange is deemed to be by reason of one of the three statutory reasons. If a safe harbor doesn’t apply, the taxpayer may be able to claim a partial exclusion if he establishes, based on the facts and circumstances, that his primary reason for the sale is one of the three statutory reasons. The final regulations provide that factors that may be relevant in determining the taxpayer’s primary reason for the sale or exchange include (but are not limited to) the following:
- Whether the sale or exchange and the circumstances giving rise to the sale or exchange are proximate in time;
- The extent to which the suitability of the property as the taxpayer’s principal residence materially changed;
- The extent to which the taxpayer’s financial ability to maintain the property was materially impaired;
- The extent to which the taxpayer used the property as her principal residence during the period she owned the property;
- The extent to which the circumstances giving rise to the sale or exchange were not reasonably foreseeable when the taxpayer began using the property as her principal residence; and,
- Whether the circumstances giving rise to the sale or exchange occurred during the period that the taxpayer owned and used the property as his principal residence.
The temporary regulations provided that a sale was treated as made because of unforeseen circumstances if an event occurred that the taxpayer did not anticipate before buying and occupying the home. Seven safe harbors were provided, including involuntary conversion and natural disasters. The final regulations revise the definition of a sale because of unforeseen circumstances from “an event that the taxpayer did not anticipate” to “an event that the taxpayer could not reasonably have anticipated” before buying and occupying the home. Thus, failure to anticipate an event’s occurrence is not enough under the final regulations if the selling taxpayer should have anticipated such an event.The final regulations also make it clear that a sale because of unforeseen circumstances (other than a sale within a safe harbor) does not qualify for the reduced maximum exclusion if the primary reason for the sale is a preference for a different residence or an improvement in financial circumstances.
Under the temporary regulations, unforeseen circumstances included events that are determined by the service to be unforeseen to the extent provided in published guidance of general applicability or in a ruling directed to a specific taxpayer. The final regulations make it clear that a taxpayer may rely only on those determinations made by the service in published guidance of general applicability or on a private ruling directed to that taxpayer. Thus, a private letter ruling to another taxpayer will not establish a safe harbor of general applicability.
Example 2: On July 15, 2003, your client, a single taxpayer, bought a condominium for $500,000 and used it as her principal residence. Her monthly condominium fee was $600. Three months after she moved into the condominium, the condominium association replaced the building’s roof and heating system. Three months after that, her monthly condominium fee was increased to $1,200 a month in order to pay for the repairs. She sold the condominium on April 15, 2004 (nine months after she bought it), for $550,000 because she was unable to afford the new condominium fee along with a monthly mortgage payment.
Under the facts and circumstances, the primary reason for the sale, the increase in the condominium fee, is an unforeseen circumstance, because your client could not reasonably have anticipated that the condominium fee would increase this much at the time she purchased and occupied the property. Accordingly, the sale of the condominium is by reason of unforeseen circumstances, and your client is entitled to claim a partial exclusion.
However, since the maximum amount she could exclude ($93,750, i.e., 9/24 of $250,000) was more than her total gain of $50,000, she could exclude the total gain. (The 9/24 equals the number of months she owned and used the condominium as her principal residence over the number of months she would have had to own and use it as her principal residence to get the maximum exclusion of $250,000.)
Example 3: On April 1, 2003, your client bought a house that he used as his principal residence for $450,000. The property is located on a heavily traveled road. On Aug. 1, 2004, your client sold the property for $480,000 because he was disturbed by the traffic. Under the facts and circumstances test, the primary reason for the sale, the traffic, was not an unforeseen circumstance since your client could reasonably have anticipated the traffic at the time he bought and occupied the house. Accordingly, your client could not exclude his gain of $30,000, since the sale was not made because of unforeseen circumstances.
Rules for military and foreign service personnel
The final regulations reflect rules contained in the Military Family Tax Relief Act of 2003. The act permits military and foreign service personnel to make an election to suspend for a maximum of 10 years the running of the five-year period while away on active duty assignments. The election may be made for only one property at a time. A taxpayer is treated as making an election by filing a return for the sale year that does not include the home sale gain in income.
A taxpayer who would qualify to exclude gain as a result of the act, but is barred by operation of any law or rule of law, may nonetheless claim a refund or credit of an overpayment of tax if he files the claim before Nov. 11, 2004.
While the final regulations generally apply for sales and exchanges after Aug. 12, 2004, a taxpayer who would otherwise qualify for an exclusion for sales or exchanges before Aug. 13, 2004, and after May 6, 1997, may elect to apply the rules of the final regulations retroactively. This can be done by either filing a return for the year of the sale or exchange that does not include the gain from the disposition of the principal residence, or, if the taxpayer has already filed a return for an open disposition year, by filing an amended return.
The final regulations relating to the provisions in the act for military and foreign service personnel apply to sales and exchanges after May 6, 1997.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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