Exclusion of Gain on a Sale of a Residence

Under prior law, two rules helped taxpayers avoid immediate tax on some or all of the profits on the sale of a principal residence. The first allowed a taxpayer to defer gain on a sale of a residence where a new residence at least equal in cost to the adjusted sales price of the old residence was bought and used within two years before or after the sale (the "rollover" provision). The second called for a one-time exclusion of up to $125,000 of gain on the sale of a principal residence. Other requirements had to be met.

Under the 1997 Tax Law, a taxpayer may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain realized on the sale or exchange of a principal residence, generally effective for sales or exchanges occurring on or after May 7, 1997. The exclusion is allowable each time a taxpayer sells a principal residence, but generally not more than once every two years. Gain would be recognized, however, to the extent of any depreciation allowable with regard to the rental or business use of a principal residence after May 6, 1997.

To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it as a principal residence for an aggregate of at least two of the five years prior to the sale. If a taxpayer fails to meet these requirements due to a change in employment, health problems, or other unforeseen circumstances, he/she may exclude the portion of the $250,000/$500,000 exclusion equal to the fraction of the two years that the requirements were met.

A number of other rules apply to the $250,000/$500,000 exclusion:

The exclusion applies to only one sale every two years, but pre-May 7, 1997, sales are not taken into account.

The new exclusion replaces the prior law's rollover and one-time $125,000 exclusion provisions. However, taxpayers may elect to have the prior laws rules (rather than the new exclusion) apply to a sale or exchange (1) made before the 1997 Tax Law enactment, (2) made after the date of enactment under binding contract in effect on that date, or (3) where a replacement residence for rollover was acquired in or before the date of enactment or under a binding contract on the date of enactment.

MARRIED COUPLES

For married individuals filing jointly the exclusion is increased to $500,000 if 1) either spouse meets the ownership test, 2) both spouses meet the use test, or 3) neither spouse is ineligible for the exclusion by virtue of a sale within the last two years. When married individuals file a joint return, they will be eligible for the $250,000 exclusion, or a prorated exclusion, if either spouse meets the ownership and use requirements.

The exclusion is determined on an individual basis. Thus, for couples that do not share a principal residence but file a joint return, a $250,000 exclusion is available for a qualifying sale of each spouse’s principal residence.

If a single taxpayer who is otherwise eligible for the exclusion marries someone who has used the exclusion within two years prior to the marriage, the otherwise eligible taxpayer would be entitled to a maximum $250,000 exclusion. The fact that the individual’s spouse used the exclusion within the past two years does not prevent the individual from claiming the exclusion.

Once both spouses satisfy the eligibility rule and two years have passed since the last exclusion was allowed to either of them, the taxpayers may exclude up to $500,000 of gain on their joint return.

EXCLUSION PRORATED

If a taxpayer does not meet the ownership or use requirements, a pro rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change of employment, health, or unforeseen circumstances (as will be defined by future regulations). The amount of the available exclusion is equal to $250,000 (or $500,000) multiplied by the portion that the shorter of (1) the aggregate periods during which the ownership and use requirements were met during the five year period ending on the date of sale or (2) the period after the date of the most recent sale bears to two years. The extent to which the exclusion is to be prorated involving unforeseen circumstances is to be determined by IRS regulations.

OWNERSHIP AND USE REQUIREMENTS

If a taxpayer acquired her/his current residence in a rollover transaction, periods of ownership and use of the prior residence are taken into account for meeting the requirements of the new exclusion.

If a residence is transferred to a taxpayer incident to a divorce, the time that the former spouse owned the residence is added to the taxpayer’s period of ownership. A taxpayer who owns a residence is deemed to use it as a principal residence while the taxpayer’s spouse or former spouse is given use of the residence under the terms of a divorce or separation.

A taxpayer’s period of ownership of a residence includes the period that the taxpayer’s deceased spouse owned the residence

A special rule provides that the exclusion may still be claimed even if the individual does not satisfy the two-year ownership and use tests and does not satisfy the requirement that the sale was due to an acceptable reason (e.g., change in the place of employment), IF the individual owned the residence on August 5, 1997, and the sale occurs during the two-year period that began on August 5, 1997.

If an individual becomes physically or mentally incapable of self-care, the individual is deemed to use a residence as a principal residence during the period in which the individual owns the residence and resides in a licensed care facility. The taxpayer must have owned and used the residence as a principal residence for an aggregate of at least one year during the five years preceding the sale.

RECORDKEEPING

The exclusion may seem to eliminate the need for many homeowners to keep records of their capital improvements. However, records should be kept, especially if there is any possibility that the gain might be required to be recognized on the sale of the residence. This situation might arise: 1) if the individuals live in the residence for a long period of time; 2) the house is rapidly appreciating in value; 3) there is a possibility that the taxpayers may claim a depreciation deduction for a home office or convert the property to a rental property; or 4) there is a possibility that the owners may not use or own the residence long enough to qualify for the exclusion.