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Home-sale tax break is a boon for most owners -- Page 2

There even are situations where owners of multiple properties might be able to double up on the tax-free gain.

"There might be instances where you sell your primary residence and then establish your vacation home as your primary home for a couple of years and then sell that home," says Trinz. "Empty nesters who have a large suburban home could move into a vacation home at the beach and then as they get older move to a residential facility so they can sell both the homes and not have any taxable gains."

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Be careful, however, if you move into a rental property you acquired through a like-kind exchange. The American Jobs Creation Act that was signed into law on Oct. 22 establishes a tougher test in these cases. If the property you convert to your principal residence is one that you earlier obtained via a property swap, in order to take advantage of the home-sale exclusion you must have acquired the property at least five years earlier.

Michael E. Kitces, director of financial planning for the Pinnacle Advisory Group in Columbia, Md., gives this example: A property is acquired by like-kind exchange in 1999, converted to personal use as a residence in 2002 and then sold in late 2004. Since the like-kind property was owned for five years, it meets the new tax code ownership-length provision. And having met the new five-year acquisition rule for a swapped property, Kitces says, the owner qualifies for the capital-gains exclusion since he lived in the property for two years after its conversion. If, however, the property had been exchanged in 2001, even if the seller had made it his principal residence shortly after the date of the swap and thereby met the two-year use rule, he still would be not be able to exclude any profits on the sale.

In either case, though, the pesky reporting requirement remains history. When your gain doesn't exceed the limit, you don't have to file anything with the IRS.

Special rules for married couples
While a husband and wife get double the exclusion of single home sellers, couples also have some additional considerations when it comes to determining whether their sale is tax-free.

Either spouse can meet the ownership test. For example, the IRS says it's OK if you owned the home for the last two years, but you just added your new husband to the title when you got married six months ago. Since you owned the residence for the requisite time, as joint filers you have no problem meeting the ownership test even though your husband wasn't an official owner for that long.

However, both husband and wife must pass the use test; that is, each must live in the residence for two years. But the shared use doesn't have to be while you file jointly. If you and your now-husband shared the home for 1½ years before tying the knot and then six months as newlyweds, the IRS will allow you to claim the exemption. But if he didn't move in until the wedding day, you're out of tax-exclusion luck.

And while you're learning about your new spouse, make sure you find out all about his or her previous home-sale history. "The two-year eligibility rule applies to both spouses, so full home disclosure is another financial area you need to consider when getting married," says Trinz. "You need to find out what you're getting."

Under this couple requirement, if either spouse sold a home and used the exclusion within two years of the sale of any jointly-owned property, the couple can't claim the exclusion. That means if your new husband sold his townhouse a month before the wedding, then you'll have to wait two years after that property's sale date before you can dispose of your shared marital residence tax-free.

Figuring the correct exclusion amount
OK, you (and your better half if you're married) met the use and ownership tests, as well as the two-year previous-sale time limit. Now it's time to do the math to avoid writing a big check to the U.S. Treasury.

As a seller, you naturally focus on how much you got for your house. That is an important number, but not the only one you'll need when it comes to figuring whether you'll owe taxes on the sale.

It's your gain, or profit, that determines the size or lack of a tax bill. In fact, you can sell your house for $1 million and still not owe Uncle Sam as long as the profit portion was not more than $250,000 or $500,000, depending on your filing status. If you can exclude all the gain, then you owe no taxes.

To arrive at your gain amount, you first must establish your basis in the home. For most people, says Trinz, this is what you paid for the residence and all capital improvements you've made, such as adding a room or finishing a basement. Also, if you sold a residence prior to the 1997 law change and rolled the profit into the home you're now selling, you must account for that rollover amount; your basis will decrease by the amount of gain you postponed years ago.

"Then you compare that basis amount to what you get from the sale, less your commissions and other expenses," says Trinz. "When you subtract your cost basis in the residence, this will give you the amount of gain on the sale."

In most instances, sellers will find they made a nice profit, but not one large enough to trigger a tax bill. Some, however, could find their residences appreciated so much that the great sales prices they got ended up costing them at tax time. That's why it's important to accurately track anything that could affect your home basis.

"In 1997 when this law first changed, there was a lot of talk about how you no longer have to keep records of home basis improvements, but the way the home prices have escalated you're probably safer in keeping those records," says Luscombe. "The improvements increase your basis, so a smaller portion of the selling price would be viewed as gain. Any overage is taxed at the [applicable long-term] capital gains rate of 15 percent or 5 percent.

"For those people, the old rule might have been better, but the new rule sort of rewards more frequent changes of homeownership."

Partial exclusion still a good deal
Even if you don't meet all the home-sale exclusion tests, your tax break might not be totally lost.

When an owner sells his house because of special conditions, such as a change in health, employment or unforeseen circumstances, he's eligible for a prorated tax-free gain.

In such a case, the seller first calculates the fractional amount of time that he met the two-year use test. For example, a single homeowner is transferred to a job in another city and sells after being in his home for only a year and a half. He would have an occupancy period of 18/24 (the number months he lived in the home divided by 24, the number of months in the two-year occupancy requirement) or 0.75. By multiplying the full $250,000 exclusion amount by 0.75, the seller would be eligible to exclude a sale gain of up to $187,500.

Members of the military also get special home-sale consideration. Because of redeployments, soldiers often find it hard to meet the residency rule and end up owing taxes when they sell. But a law change in 2003 now exempts military personnel from the two-year use requirement (for up to 10 years), letting them qualify for the full exclusion whenever they must move to fulfill service commitments.

So quit worrying about taxes when you put your house on the market. Chances are good that Uncle Sam won't be able to lay any claim to your hefty home-sale profit.

-- Posted: May 16, 2005

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