HOME SELLERS’ TAX LAW

The 1997 Tax Law for Home Sellers was approved by Congress on May 7, 1997, and signed by the President on 8/5/97. California followed shortly thereafter, so we have the same rules for both Federal and California. There’s lots of fine print and complexity. Make sure you discuss the particulars with your tax adviser before acting on this information.

For more information, see 1997 Tax Act Question and Answer Index.

10/31/2001: IRS Rejects “Deemed Sale” for Personal Residence.

HOME SELLER TAX RULES

It’s easy. No more rollover, no more over-55 rule (with its once in a lifetime and tainted spouse limitations).

Effective May 7, 1997, if you meet 3 tests, you qualify. It does not matter what you do with the money. You do not have to buy a new home. There is NO MORE ROLLOVER.

 

  1. USE TEST:” Did you live in the property as your principal residence for any 2 year total period within the last 5 years looking back from the date of sale?
    • The 2 years do not have to be consecutive periods – it might be one day at a time, as long as it totals 2 years. 
    • You don’t have to own it for 5 years; merely own it for 2 within the last 5 years. 
  2. OWNERSHIP TEST:” Did you own the property for a 2 year total period within the last 5 years? For a married couple, only 1 spouse needs to be an owner for both to qualify, if both spouses meet the Use Test
  3. BEFORE TEST:” Did you do a tax free sale within the last 2 years?

EXCLUSION AMOUNTS

  • single person can exclude $250,000 of profit; 
  • married couple filing a joint return can exclude $500,000 [even if only 1 spouse meets the 2 out of 5 year ownership requirement, as long as they both lived there 2 years].[This probably allows a single person to sell his home today, get married on New Years Eve, and file a joint return excluding $500,000, as long as either spouse owned for at least 2 years, both spouses lived in the residence for 2 years, and neither sold a home tax free within the last 2 years.]

     

This rule can be used every 2 years. There is no more lifetime “tainted spouse” rule; the taint now wears off after 2 years!

Unlike the old law, now the property can be rented for several years and then sold.

My dentist is married and bought his home 20 years ago for $72,000. If he sells it for $800,000 his profit is $800,000 – 72,000 = $728,000. This is reduced by $500,000 since he meets the requirements of the new law. His age and whether he buys a new home is irrelevant. He has to pay tax on $228,000.

For a Worksheet to help compute the taxable profit on the sale of your home, see 1997 Act Worksheet.

  • Although §1034 (the 2 year rollover rule) is repealed, the adjusted basis today is computed with reference to profit rolled over previously under §1034 (the OLD 2 year rollover rule). All my previously rolled over profit from every home I ever owned and rolled over, is now potentially taxable. 

Reduced Exclusion: Proportional Rule

If you do not meet the 2 year rules, in 3 circumstances you may use the “reduced exclusion.”

If you move due to:

  1. change in place of employment,
  2. change in health, or
  3. special reasons.

See 12/24/02 Reduced Exclusion Requirements.

IF you meet one of those special circumstances, the exclusion amount is pro-rated. If you owned (or lived in) your home 16 months in the 5 years prior to the sale, you may exclude 66.6% (16/24ths) of the full exclusion amount ($250,000 / $500,000). If your profit is less than 66.6% of your $250,000 or $500,000 exclusion, nothing is taxable.

 

IRS claims that you may use the reduced exclusion only if you have not owned the home for 2 years, nor lived in it for 2 years. This means that if you have a rental property owned for many years, and have $250,000 of built-in profit, you and your spouse may not move in for 1 year and then sell and exempt all your profit (or half of the full exclusion amount), assuming that you meet one of the special circumstances allowing you to use the reduced exclusion. I am not convinced that this is an accurate interpretation of this new law but that is the present IRS position.

 

DIVORCE BREAK

Finally, we have a break for the “out spouse” after divorce.

 

  • [Previously, if husband left the residence (either while the divorce was pending or afterward) and it was then sold, technically he was ineligible to use the 2 year rollover rule: it was no longer his residence (even if he had left the home last month).] 

Now, the “out spouse” is eligible for these benefits if the “in spouse” is eligible, even if the “out spouse” has been out for many years if the sale is pursuant to the divorce or separation agreement.

 

Disaster Loss

If there is a disaster covered by insurance, it is taxed as a sale, rather than under the complex rules formerly applicable to such involuntary conversions.

 

Other Rules

  • Time spent in a licensed facility for a person who formerly lived in the primary residence for at least 1 year out of the last 5 but is incapable of self-care still counts as time in the primary residence. 
    • Grandma lived in the primary residence until she could no longer care for herself and went into the nursing home almost 4 years ago. She qualifies for the 2 of 5 years rule. 

Still want to use the old law?

Some people like my dentist might be better off under the old 2 year rollover rule. Tough. There is no more rollover.

 

1031

The 10/2004 Tax Law changed the rules for sale of a personal residence acquired in a 1031 exchange.  The primary residence cannot be sold (tax free) for 5 years after its acquisition; in other words, you must own it 5 years before you may sell it as a primary residence.  New Section 121(g).

NOTE:  Some people believe that this 2004 law gives us guidance and permission to convert a former investment property to a personal residence.  However, I think that the intention at the time of the exchange to rent it for the ‘impliedly required’ 3 years before converting to personal and living there 2 years (to meet the new 5 year ownership test) INVALIDATES the 1031 exchange.

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