Final and Temp. Sec. 121 Regs. on Gain Exclusion

As the economy continues on somewhat unsteady ground and the stock market re-mains uncertain, saving taxes might not be an investors primary concern. However, this is not the case for homeowners realizing large gains on the sale of their homes, as the real estate market, at the moment, remains recession proof. Thus, many homeowners probably breathed a sigh of relief when the IRS recently issued final, temporary and proposed regulations on excluding gain from the sale of a principal residence.

The Taxpayer Relief Act of 1997 substituted the Sec. 1034 rules with regulations that allow taxpayers to exclude $250,000 ($500,000 for joint returns) on the sale or exchange of a principal residence they owned and lived in for two of the five years before the sale. Taxpayers can generally use the gain exclusion repeatedly, but not more than once every two years. The new regulations also clarify the definition of personal residence. Further, changes in the new regulations affect how taxpayers can (1) exclude gain from the sale of vacant land used as part of a residence, (2) allocate gain between business and residential uses of a home, (3) apply the rules if unmarried joint owners, (4) fulfill the ownership and use tests and (5) exclude at least part of the gain when they fail to meet those tests.

While the final and temporary regulations apply to sales occurring after Dec. 23, 2002, taxpayers may retroactively apply the rules to any sale occurring after May 7, 1997, by filing an amended return. Thus, a taxpayer who has already reported gain from the sale of a residence and qualifies for a reduced maximum exclusion under the new regulations can file Form 1040X, if the period for filing an amended return has not closed. He or she can also elect not to claim the exclusion within three years of the returns due date for the sale year.

Gain on Sale of Vacant Land

Regs. Sec. 1.121-1(b)(3) allows only one maximum exclusion for both a residence and vacant land. The vacant land must be adjacent to the dwelling unit of a taxpayers principal residence, the dwelling unit must be sold or exchanged within two years before or after the sale or exchange date of the vacant land, and the vacant land must have been used by the taxpayer as part of the principal residence. Thus, if the taxpayer sells the land before selling the principal residence adjacent to such land, he or she would have to recognize gain in the sale year. If the taxpayer then sells the principal residence within two years of selling the land, he or she could file an amended return to claim an exclusion of the gain from the land sale. Note: The total gain exclusion from both sales is $250,000 ($500,000 for joint filers).

Gain Allocation between Residential and Business Uses

Significantly, Regs. Sec. 1.121-1(e) does not require taxpayers to allocate gain from the sale of property used partially for residential purposes and partially for nonresidential purposes (e.g., either as rental property or as part of a business). If the residential and nonresidential portions are within the same dwelling unit, no allocation is needed; only the portion of the gain attributable to the depreciation taken on the nonresidential portion would be taxable. If, however, the nonresidential portion is located separately from the dwelling unit, any depreciation taken on such portion would be recaptured; any gain allocable to such portion (in addition to the depreciation recapture) is includible.

Failing the Ownership and Use Tests

For qualified taxpayers who do not meet the ownership and use tests, a reduced maximum exclusion is available if the primary reason for the home sale was due to (1) a change in place of employment, (2) health reasons or (3) unforeseen circumstances, as described in Temp. Regs. Sec. 1.121-3T(b). The IRS may determine other events that qualify.

A qualified taxpayer means the taxpayer, the taxpayers spouse, a co-owner of the residence or a person whose principal place of abode is in the same household as the taxpayer, according to Temp. Regs. Sec. 1.121-3T(f). In the case of a sale or exchange for health reasons, a qualified individual also includes a person bearing a relationship (as specified in Sec. 152(a)(1)(8)) to one of the above-mentioned qualified taxpayers or a descendant of the taxpayers grandparent.

Changing employment location. The same distance rules that apply to a moving-expense deduction would also apply to determine if the reduced exclusion on the sale of a principal residence is allowable.

Health reasons. Under Temp. Regs. Sec. 1.121-3T(d), a sale is necessary for health reasons if it is to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of a disease, illness or injury of a qualified individual. A sale merely beneficial to general health or well-being does not qualify. A physicians recommendation is sufficient evidence to determine that the taxpayers health is the primary reason for the sale.

Unforeseen circumstances. A taxpayer may qualify for the reduced maximum exclusion if the sale of his or her primary residence is due to unforeseen circumstances, which, under Temp. Regs. Sec. 1.121-3T(e)(2), includes the involuntary conversion of the residence; natural or manmade disasters or acts of war or terrorism resulting in a casualty to the residence; and, in the case of a qualified individual, death; cessation of employment for which the taxpayer is eligible for unemployment; change in employment that renders the taxpayer unable to pay housing costs; divorce or legal separation; or multiple births resulting from the same pregnancy.

From Eileen M. Cooney and Michael Greenwald, CPA, New York, NY