Capital gains home-sale tax break a boon for owners

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.