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12/24/2002: IRS ISSUES HOME SELLER REGULATIONS

IRS has issued regulations regarding the Home Seller Tax Law passed by Congress in May, 1997. These new Regulations (Regs) were released on 12/24/2002, and contain some very nice presents for Taxpayers.

The original law is §121 of the Tax Code. The new Regs are 1.121- 1, etc.

To recap, the law requires that you:

  1. USE the home as your Principal Residence for 2 of the 5 years before the sale of the home; and
  2. OWN the home for 2 of the 5 years before the sale of the home.
  3. Finally, you must wait 2 years before selling a home tax free again. (I.e. You have not sold a home tax free within the 2 years before this sale.)
Sounds simple. Now the IRS has explained their position on many of the complications which can arise.

The law applies to a Principal Residence. That is now defined, kind of.

If you have more than 1 Residence, the determination of which is your Principal Residence depends on all of the facts. Most important is in which property you spend a majority of your time. Additional factors include but are not limited to: place of employment; abode of immediate family members; address for government purposes (tax filing, DMV, voting); mailing address for bills and correspondence; location of banks; location of clubs and religious organizations.

There is much discussion in the Regs about whether vacant land adjacent to the Residence qualifies for the exclusion. IRS Example: Clara owns a house on 10 acres; she sells 8 acres to Bob and next year the house and 2 acres to Sam. Clara can treat both sales as if they were 1 sale at the same time, excluding up to $250,000 of gain.

[I don't expect this to apply to many readers, but it illustrates how friendly an approach the IRS has taken with these Regs.]

USE

To measure the 2 years of use, short temporary absences count as use.

IRS previously, and again now, clarifies that a property now used as a rental, previously used as a Residence, qualifies for the exclusion. They did not address how §1031 might work in conjunction with such a sale.

Use does not have to be concurrent with ownership: Tom likes his rental so much he buys it after living there 2 years. Then he moves out and turns it into a rental. After 2 years, he qualifies, even though his use was before his ownership.

Partly used as Principal Residence:

HOME OFFICE: The IRS has given us an incredible present. In 2000 the Home Office Rules were liberalized. Then the law allowed exclusion of gain for the Residence. (Those were gifts from Congress.)

    We all assumed that the home office portion was not eligible for exclusion. Example: If I bought for $400,000, and used 25% as a home office, and took $30,000 depreciation over the years on the home office, when I sell for $600,000, (profit of $200,000) I can exempt all the $150,000 profit on the portion used as the home, but 25% of the profit ($50,000) is attributable to the home office, not eligible for exclusion.

    We thought the only solution was to discontinue using the home office for 2 years before the sale. (That would work to qualify the entire $200,000 profit for the exclusion, but there would still be depreciation recapture.)

Now the IRS present: IRS Reg 1.121-1(e)(1) states that allocation of profit to the non-qualified use is NOT required IF the home office is entirely in the same dwelling unit. Let's simplify that: If it's inside your home, although the depreciation recapture is still taxable, the profit is eligible for exclusion!

Back to the example: My $200,000 profit is excluded. (I still have depreciation recapture of $30,000.

    IF the business use is on the grounds of your home, but not within the dwelling unit (example: home office in an outbuilding, or a stable business behind the home) profit attributable to the business portion is taxable.

    IRS Example: A duplex: one-half is rented, one-half used by the Owner. The portion of profit attributable to the rental does not qualify for the home sale exclusion.

    IRS Example: A duplex: one-half is rented, one-half used by the Owner. Then Owner merges the 2 into 1 unit; lives there 2 years more; all of the profit is eligible for the exclusion. (There is still depreciation recapture.)

MARRIED COUPLES:

To claim the $500,000 exclusion, both spouses must meet the Use Test; either 1 may meet the Ownership Test. [This is NOT NEW, but most people forget this rule.]

    IRS Example 3: H and W each live alone; they marry, sell their old homes, and buy a new home. Each may exclude up to $250,000. If W's profit is $300,000, and H's profit is $150,000, she may NOT use H's extra exclusion.

    IRS Example 5: H dies 2/1/2003. W sells 11/1/2003, the same year. W may file Jointly (with her dead H) and exclude $500,000. [Of course, IRS neglected to mention the step-up in basis which eliminates all / most of the profit.]

    IRS Example 6: H dies 2/1/2003. W sells 1/2004, the next year. She may NOT file Jointly and may exclude only $250,000. [Of course, IRS neglected to mention the step-up in basis which eliminates all / most of the profit.]

    IRS Example: H, a newly-wed, dies. W inherits. She is treated as living and owning the property for the entire time H owned and lived there.

    IRS Example: H divorces. W gets the home. She is treated as living and owning the property for the entire time H owned and lived there.

Multiple Owners each get their own exclusion. (3 guys who own a home can each qualify for $250,000.)

Multiple sales of the Same Residence:

My profit is more than the exclusion amount. May I sell half the home now (to my Daughter), and wait 2 years and do it again to get another tax free exclusion? No, IRS allows only 1 exclusion per Residence, no matter how long you wait. 1.121-4(e)

IRS has also issued Temporary Proposed Regs regarding the Reduced Exclusion (Proportional Rule) if you do not meet the 2 year tests.

All of these Regs may be applied retroactively.

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