It appears that there is still some confusion about the rules for taxing the gain on the sale of a personal residence. Many people think the “old rules” still apply. Here is a quick review.
THE OLD RULES:
In order to postpone paying income tax in the current year on the gain from the sale of your personal residence you had to “buy up” – purchase, or build, a new home that cost more than the sale price of your old home – within 2 years of the date you closed on the sale of your old home. The tax was deferred for as long as you continued to “buy up”, or until you sold your last home.
Homeowners age 55 and older could make a once-in-a-lifetime election to exclude up to $125,000.00 in gain.
These rules no longer exist!
THE NEW RULES:
Thanks to the Tax Reform Act of 1997, if you sell your personal residence after May 6, 1997, you can totally exclude from income up to $250,000.00 of gain if single, or $500,000.00 if married, regardless of your age at the time of the sale, if during the 5 years prior to the sale you owned and lived in the home for a total of 24 months (they do not have to be consecutive). The exclusion is not a one-time election – it is available once every 2 years.
If you are married and sell your home, which you and your spouse owned and lived in for 3 years, and realize a gain of $475,000.00 you do not have to pay any income tax on this gain. If the net gain is $525,000.00 you will only pay tax on $25,000.00 at the appropriate capital gains rate.
If you do not own and live in the home for a full 24 months you may still be able to exclude some, or all, of the gain if the primary reason for the selling the home is a change in employment, a change in health, or an "unforeseen circumstance". An unforeseen circumstance is described as "an event the taxpayer doesn’t anticipate before purchasing or occupying the residence".
Two recent private letter rulings give an idea of what the IRS considers to be qualified "unforeseen circumstances" -
(1) A police officer and his wife purchased a townhouse to be used as their principal residence. After signing the purchase contract, but before the closing, the officer applied to train with the K-9 unit of the police force. After moving into the townhouse the officer was notified that he was accepted to the unit. A K-9 officer is required to maintain a 6x9 foot kennel in his/her home for his/her "partner". The homeowners association for the townhouse did not permit kennels. The taxpayers sold the home before they had lived in it for two years. In PLR200504012 the IRS permitted a partial exclusion.
(2) A taxpayer purchased a home to be used as his principal residence. Less than two years later he was attacked outside of his house. The attacker put a gun to the taxpayer’s head, forced him into his vehicle, and demanded that he drive his attacker to various locations over a period of an hour. The taxpayer was forced to use his ATM card to get cash for the criminal. Traumatized by the event, and afraid to continue living in his home, the taxpayer moved and rented out the property. When the tenant moved out he sold the home. In PLR 200630004 the IRS permitted a partial exclusion.
The amount of the exclusion allowed in such a case is determined by dividing the number of months owned and used as a personal residence by 24 months and multiplying the answer by the $250,000.00 or $500,000.00 maximum allowed. If you and your spouse owned and lived in the home for 12 months you could exclude up to $250,000.00 ($500,000.00 x 1/2).
You should still keep the original Closing or Settlement Statement for the purchase of your home for as long as you own it, and maintain documentation on all capital improvements made to the home over the years just in case.