ASK THE TAX PRO: AN EXCEPTION TO THE 2-YEAR OWNERSHIP AND RESIDENCE RULE

I recently received a tax question from a reader that was submitted as a comment to a totally unrelated TWTP post. 

Here is the comment -

“Hello,

My wife and I bought our current home as our primary home n Temecula, CA and closed escrow on 9/28/12. We sold a townhome which was our primary which we lived in for 7 years in Carlsbad, CA before buying our current home in Temecula, CA. I work for a company working remotely from home.

We are putting our house up for sale as of 6/20/14 and I received approval from my manager to relocate at my own expense back to Overland Park, KS, so we can be closer to my mother-in-law as she has multiple sclerosis and her son lives with her working full time and he needs help taking care of her.

If we sell our home before the 2 years is up what sort of paperwork would I need to have in case the IRS asks me about paying capital gains tax on our profit since we have lived less than 2 years in our home. I can always just have the potential buyer not close until after 9/28/14 so we have lived in our primary home for 2 years. We would make around 165K profit so we would meet the married filing joint proration criteria.

If we sell and close escrow before the 2 years is up then would I meet the over 50 miles job transfer criteria since I approached my company to relocate and/or would I need my mother-in-law to provide medical documentation show she has multiple sclerosis. I just don't want to have to pay capital gains tax which would amount to around a 40k tax bill if the IRS doesn't feel we have sufficient evidence for selling our home and moving without living in our home for 2 years.

Any info would be appreciate. Thanks.

David Allen”

First let’s address the issue of not owning and living in the home for 24 months during the 5 year period prior to sale.

Here is what we are told in IRS Publication 523 “Selling Your Home” (highlight is mine)  -

“If you fail to meet the requirements to qualify for the $250,000 or $500,000 exclusion, you may still qualify for a reduced exclusion. This applies to those who:

• Fail to meet the ownership and use tests, or

• Have used the exclusion within 2 years of selling their current home.

In both cases, to qualify for a reduced exclusion, the sale of your main home must be due to one of the following reasons.

• A change in place of employment.

• Health.

• Unforeseen circumstances.”

And

“The sale of your main home is because of health if your primary reason for the sale is:

• To obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or

• To obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury.

The sale of your home is not because of health if the sale merely benefits a qualified individual's general health or well-being.

For purposes of this reason, a qualified individual includes, in addition to the individuals listed earlier under Qualified individual , any of the following family members of these individuals.

• Parent, grandparent, stepmother, stepfather.

• Child, grandchild, stepchild, adopted child, eligible foster child.

• Brother, sister, stepbrother, stepsister, half-brother, half-sister.

• Mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, or daughter-in-law.

• Uncle, aunt, nephew, niece, or cousin.

Example.

In 2012, Chase and Lauren, spouses, bought a house that they used as their main home. Lauren's father has a chronic disease and is unable to care for himself. In 2013, Chase and Lauren sold their home in order to move into Lauren's father's house to provide care for him. Because the primary reason for the sale of their home was to provide care for Lauren's father, Chase and Lauren are entitled to a reduced maximum exclusion.”

You can exclude a portion of your gain if you are selling your home and lived there less than 2 years and you meet one of the three exceptions.  The $500,000 maximum exclusion is pro-rated based on the period of residence.

The website of legal publisher NOLO has this to say in “Exceptions to the Home Sale Exclusion Two Year Rule” from Stephen Fishman, J.D -

“Health problems are a valid excuse if a doctor recommends that you move for health reasons—for example, you have asthma and your doctor tells you that living in Arizona would be better for you than Maine. The health problems can belong to you, your spouse, any co-owner of the property, any other person who uses your home as his or her principal residence, or a close family member of any person in the prior categories—for example, a child or parent. Thus, for example, you can move if you need to be closer to an ill parent. If you want to use the health exception, be sure to get a letter from your doctor stating that the move is for health reasons and what they are. Keep the letter with your tax files.”

The safest way to secure the exception to the 2-year rule is to obtain an IRS Private Letter Ruling – but this is truly very expensive.  Before selling the home I would get a letter from the mother’s doctor stating her medical condition and her need for personal care.  I would also get a letter from the brother stating that he is unable to provide continual care because of his full-time employment.  These letters do not to be attached to the 2014 tax return, but should be available in case of an inquiry.

If the sale of the home closes prior to 9/28/2014, the couple can still report the sale on the 2014 Schedule D and claim the Section 121 exclusion.  A statement should to be attached to the return explaining why the period of ownership and residence is less than 2 years and including the calculation of the reduced maximum exclusion amount.

As for the question of deducting moving expenses (not specifically asked, but alluded to in the reference to the “over 50 miles job transfer criteria”) – since the move from California to Kansas is not at all job-related none of the moving expenses are deductible.

IRS Publication 521 “Moving Expenses” says -

“You can deduct your moving expenses if you meet all three of the following requirements.

•Your move is closely related to the start of work.

•You meet the distance test.

•You meet the time test.”

While the distance and, I expect, the time tests will be met, the move is personally motivated and has nothing whatsoever to do with DA’s employment.  He works out of his home.  He is not moving to start a new job or because his company is relocating.  He is moving to be able to take care of a qualified family member.  .   

I hope this post satisfactorily answers the questions posed by Mr. Allen.  Does anyone out there have any additional comments or suggestions, or disagree with anything I have said?

TTFN