IRS Issues Final Rules on Gain or Sale of Principal Residence

August 25, 2004

Ann vom Eigen, Legislative and Regulatory Counsel

IRS Issues Final Rules on Reduced Maximum Exclusion of Gain from Sale or Exchange of Principal Residence

Summary: The IRS has finalized rules for the treatment of taxpayers who do not qualify for the maximum exclusion of capital gains on home sales because they have not owned and used their property as their principal residence for two of the past five years, or have taken an exclusion within the preceding two years. The rules significantly expand the situations under which capital gains exclusions may be taken. This memo is designed to provide background information on the new rules. At closing, you should continue, when completing the Form 1099-S to simply fill in the full amount of the gross proceeds of the sale, and not attempt to calculate capital gains. Final Rules: Under the IRS Code, a taxpayer may exclude up to $250,000, ($500,000 for joint returns) of gain realized on the sale or exchange of the taxpayer’s principal residence if they owned and used the property for at least two of the last five years. In general, the maximum exclusion is applicable to only one sale or exchange during the two-year period. The new IRS rules specify the conditions under which a taxpayer who fails to meet any of the conditions by reason of (1) a change in place of employment (2) health, or (3) unforeseen circumstances, may be entitled to an exclusion in a reduced maximum amount.

Fact And Circumstances: The rule establishes safe harbors under which taxpayers may qualify for the exclusion, and also provides a “facts and circumstances” test to allow flexibility for the Service and taxpayer to evaluate a particular situation.

Unforeseen Circumstances: The rule also describes safe harbors which allow the sale or exchange to be deemed eligible “by reason of” a change in place of employment, health, or unforeseen circumstances. The new regulations expand the legal test for the definition of sale or exchange for unforeseen circumstances to an event that a taxpayer could not reasonably have anticipated, but excludes preferences for a different residence or an improvement in financial circumstances as a qualification for the exclusion. The final regulations also specify that qualified individuals who can be affected by these changes are not limited to only the taxpayer and spouse. Rather, it expands the test to allow events affecting co-owners and co-inhabitants to be considered.

Health Exception: A sale or exchange is by reason of health if the primary reason for the sale or exchange 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 medial or personal care for a qualified individual suffering from a disease, illness or injury.

Military Exception: A taxpayer serving, (or whose spouse is serving) on qualified official extended duty as a member of the uniformed services or Foreign Service may elect to suspend the running of the 5 year period for up to 10 years. The exception for members of the Foreign Service and the military is retroactive to May 7, 1997.

Retroactive Effective Date: The rule is effective on August 13, 2004. However, taxpayers may elect to apply the rules retroactively for sales on or after May 7, 1997.

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