Home Sale Rules Clarified

By Roy Lewis (TMF Taxes)
January 31, 2004

The Taxpayer Relief Act of 1997 turned the home sale gain rules on its head. Under the new law, generally effective for property sales after May 6, 1997, up to $250,000 of the gain from the sale of a single person's principal residence is tax-free. That's right -- tax-free. And, for certain married couples filing a joint tax return, the amount of tax-free gain doubles to $500,000.

Gone were the old rules where you could "buy up" and avoid current taxes on the sale of a principal residence. Gone also was the "once in a lifetime" gain exclusion provisions.

However, there were many questions in the original law that were difficult to resolve without additional help from Uncle Sam. Well, the final regulations on these issues have recently been issued. Surprising to many tax pros, these final regulations are liberal. Not only that, the new rules can be applied retroactively to any prior sales that have occurred.

The "retroactivity" of these new regulations can be very good news for taxpayers who sold their homes in the recent past and were a bit unsure of the applicable tax treatment and how the IRS might apply the previously unwritten rules. Well, now we know. And this is a very big deal!

Definition of principal residence
One of the most perplexing issues in the new law was the definition of a principal residence. Under the old law, many issues dealing with the definition of a principal residence had been ruled on by the courts. But many tax pros were unsure if those definitions would also apply to the new law. If you have multiple homes, and spend considerable time in each, this becomes an extremely important issue.

The IRS says that, generally, your principal residence will be the home where you spend the majority of your time. But this isn't the only test. Other factors that will be relevant to the determination include but are not limited to:

Your place of employment
Where your family lives
The address you use on your tax return
The address you use for your general mail, bills, bank statements, and brokerage statements
Where you maintain your bank accounts and banking relationships
Where you maintain your memberships (such as country clubs, health clubs, etc.) and religious affiliations

Not stated in the regulations but important to the determination of your principal residence are:

Where you are registered to vote
The address on your driver's license
The property on which you claim your homeowners property tax exemption (many states and counties allow for the payment of lower property taxes on your principal residence)

None of these issues will provide a clear definition of your principal residence. As noted in the regulations, all of the facts and circumstances will be considered. If you have a second, third, or even a vacation home that you are considering selling and would like to avail yourself of the gain exclusion rules, make sure that it'll qualify as your personal residence taking into consideration all of the issues noted above.

Partial-gain exclusion
As noted in my article Home Sale Tax Exclusions: Special Rules for Married Folks, there are special rules that come into play to allow for at least a partial exclusion of the gain on the sale even if you didn't live in the property for the required two-year period. The law stated that if the move was due to (1) a change of your place of employment, or (2) health, or (3) unforeseen circumstances, a partial exclusion would be allowed. Sadly, the IRS was silent on the definition of these provisions... until recently.

Change in place of employment: The IRS says that this is a change of employment or self-employment for any of the following people (a "qualified individual"):

You
Your spouse
A co-owner of the property in question (such as a live-in partner with an ownership interest in the property)
A person whose principal place of abode is in your home

But a simple change of employment across town won't be enough to trigger the partial-gain exclusion. The new place of employment for the qualifying individual must be at least 50 miles farther away from the residence being sold than was the former place of employment. If there was no former place of employment (such as the beginning of a new venture or following a term of unemployment), the distance between the new place of employment and the residence being sold must be at least 50 miles. In effect, these are the same distance rules that apply for the deduction of moving expenses.

But even if the distance test isn't met, don't give up hope. The reduced exclusion is still allowed if the facts and circumstances indicate that the home sale was primarily due to a change in the place of employment, and the IRS provides two examples in the regulations (see Temp. Reg. 1.121-3T).

Health reasons: The IRS says that a sale is primarily for health reasons when the facts and circumstances indicate that the move is specifically related to a disease, illness, or injury of a qualified person. For this section, a qualified individual includes not only those mentioned above but also:

A person who is related to any of the "qualified individuals," either by blood or marriage, or
A descendant of your grandparent (such as your first cousin)

I'll not bore you with all of the official language. Suffice it to say that this is a really broad definition of who is "related" to you, and would include virtually anybody that you would consider related in the true sense of the word. But if you are moving because of the health issues of the third cousin of your father-in-law from your second marriage, you'll want to check out the actual definitions just to make sure that you qualify for the reduced exclusion.

And, as always, a move that is simply and only beneficial to the general health or well-being of any of these individuals will not be considered primarily for health reasons. Moving to Arizona to "feel better" in the warm winter environs just isn't enough to qualify for the exclusion.

Unforeseen circumstances: The actual law on this issue basically states that there are no unforeseen circumstances until and unless they are defined in the regulations. This has been a touchy issue because until this time, the IRS hadn't provided guidance as to what would constitute such a circumstance. Well, they're here now, and better than some had hoped for.

The IRS says that you'll have unforeseen circumstances (and therefore be eligible for the partial-gain exclusion) if any of the following events occur to the qualifying individual during the ownership and use of the property as principal residence:

Involuntary conversion of the home
Natural or man-made disaster or act of war or terrorism resulting in a casualty to the home
Death
Cessation of employment, making him/her eligible for unemployment compensation
Change in employment or self-employment that results in the inability to pay housing costs and basic living expenses
Divorce or legal separation under a decree of divorce or separate maintenance
Multiple births resulting from the same pregnancy

None of these apply to you? Don't worry. The IRS says that you can still qualify for the reduced-gain exclusion if the facts and circumstances indicate that the primary reason for the home sale is due to the occurrence of an event that you didn't anticipate before purchasing and occupying the property.

The regulations again provide two examples of these situations, which seem to indicate that the IRS will be fairly liberal in their interpretation of the rules. So again, if you were required to sell your property before the two-year period had lapsed, and none of the above specific circumstances applies in your case, make sure that you (or your tax pro) have reviewed the regulations to see if Uncle Sam might consider your specific issues "unforeseen circumstances."

There are other issues that were clarified by the IRS with respect to the home sale gain exclusion, and we'll discuss them next week.

Taxes and Your New Home

By Roy Lewis (TMF Taxes)
September 6, 2004

In this article we're going to talk about the tax issues associated with buying a home. (Please also see The Motley Fool's Home Center area for more help with the non-tax aspects of home buying.) We're talking about the purchase of your principal or primary residence here, the property where you live and hang the "Home Sweet Home" sign over the front door.

We're not talking about rental properties, investment properties, vacation home properties, second homes, or anything else. While the basic concepts may be similar for all properties, they are not exactly the same. So, if your purchase is something other than your principal residence, use this article for some basic background and then do the appropriate research to find out how your specific purchase will be affected.

When you begin your home purchase, you'll be dealing with a third party to help you close the deal. Depending on where you live, this third party could be an attorney, an escrow company, a title company, or some other person or company. This third party is charged with making sure that the property's title is properly transferred to you, that your loan is in place, and that all of the costs and expenses associated with the purchase are properly allocated.

You'll be charged various fees to purchase your property, such as closing fees, title fees, transfer fees, transfer taxes, homeowner association fees/assessments, etc. You might even be charged prorated interest, property taxes, and loan "points."

Generally, with the exception of the prorated interest on the loan, property taxes, and points (which we'll discuss in a few moments), the other expenses you are assessed to purchase the property are not deductible anywhere on your tax return.

They really represent expenses required to purchase your property, so they are treated as an additional cost of the property (an addition to the tax basis of the property, if you will). Think of these expenses as you would broker commissions that you pay when you purchase stock. Those broker commissions are also not deductible, but attach themselves to the cost of the stock. Your closing costs work exactly the same way -- not currently deductible, but they increase the tax cost (or basis) of the property.

So, the only way you'll receive any tax benefit for these charges is to sell the property. When you sell, you'll use these purchase costs as an addition to your tax basis, and compute your gain or loss on the difference between your net sales price and your cost basis (plus any improvements you've made to the property).

As you are likely aware, the new rules regarding the exclusion of the gain on the sale of a principal residence for qualified taxpayers might mean that you'll not receive any tax benefit for these costs. But I'm sure that you'll gladly trade off the tax-free gain treatment on your subsequent sale against these closing costs. (If you are unsure how the gain exclusion rules actually work, see my multi-part discussion of this issue entitled "Home Sale Exclusions" -- Part I, Part II, and Part III.)

Qualified first-time homebuyers can use IRA funds to pay the required closing costs for a recent purchase -- and those IRA funds can be removed without penalty (but not without tax). For a detailed discussion of this, please see my article entitled "IRA Withdrawal for Homebuyers."

So, you've now determined that your closing costs are not deductible, but what about the other items we mentioned -- prorated property taxes, interest, and loan points? Well, the news gets a little bit better regarding those expenses.

Prorated property taxes
When you purchase your property, you'll very likely get hit with some prorated property taxes. Why? Because, for federal income tax purposes, the seller is treated as paying the property taxes up to the date of sale. You (the buyer) are treated as paying the taxes beginning with the date of sale. This applies regardless of the lien dates under local or county law.

Generally, this information is included on the settlement statement you get at closing. You and the seller each are considered to have paid your own share of the taxes, even if one or the other paid the entire amount. You can each deduct your own share as a Schedule A itemized deduction, assuming you itemize, in the year the property is purchased.

But if part of your deal has to do with delinquent taxes, beware. Delinquent taxes are unpaid taxes that were imposed on the seller for an earlier tax year. If you agree to pay delinquent taxes when you buy your home, you cannot deduct them. Instead, those delinquent taxes are treated as part of the cost of your home, just like the other non-deductible closing costs discussed earlier.

Prorated mortgage interest
It's very likely that you'll get hit with a few dollars of interest for your new home loan on your closing statement. Assuming that you are able to deduct your mortgage interest (under the home mortgage interest rules), you'll be able to also deduct this interest as an itemized deduction on your Schedule A.

Generally, this interest (along with all of the other interest that you paid on your home mortgage) will be reported to you at the end of the year (via Form 1098) by your mortgage holder, but make sure that these interest payments are actually included in your year-end report from your lender. Many times, your mortgage loan will be sold or transferred to another mortgage lender soon after your closing, and sometimes these interim interest expenses get lost in the shuffle. So, it's your responsibility to determine if these prorated interest charges are reported to you properly.

The rules regarding deductible home mortgage interest are really pretty easy to understand, but a bit outside the scope of this article. To read more about deductible mortgage interest on your new principal residence, check out IRS Publication 936 at the IRS website.

Loan points
The term "points" is used to describe certain charges paid, or treated as paid, by you to obtain a home mortgage. Points may also be called "loan origination fees," "maximum loan charges," "loan discount," or "discount points."

The general rule is that you can't deduct the full amount of points in the year that they are paid, because they are nothing more than prepaid interest. Accordingly, you are required to deduct (or amortize) them over the life of the mortgage. But don't panic.. As with most tax issues, the general rule is only the starting point, and you'll want to learn more about the exceptions. So, here they come:

You can fully deduct points in the year paid if you meet all of the following tests:

The loan is secured by your principal residence.
Paying points is an established business practice in the area where the loan was made.
The points paid were not more than the points generally charged in that area.
You use the cash method of accounting. (This means you report income in the year you receive it and deduct expenses in the year you pay them. Most individuals use this method.)
The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
You use your loan to buy or build your principal residence.
The points were computed as a percentage of the principal amount of the mortgage.
The amount is clearly shown on the settlement statement (for example, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller's funds.
The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided do not have to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.

If you meet all of the above criteria, you'll find that your points are deductible in full in the year of closing, and you can use them as an itemized deduction on your Schedule A.

Points, especially points paid by the seller in the transaction, can get tricky. So you'll want to read more about them in IRS Publication 936.

There you have it -- the basic tax issues involved with buying your principal residence. But these are not all of the issues involved, by any means. If you are buying a home, you'll want to read more about the related tax issues in IRS Publication 530.