Last month, we were discussing excluding taxable gain on the sale of probably your biggest asset, your home.  The general rule is that you must have owned and lived in the house for at least two of the five years prior to the sale and not have used the exclusion during a two year look back period in order to exclude gain.  As often as it is in the real world, your tax situation might not quite fit into these parameters, hence the reduced exclusion rules.

Reduced Exclusion Rules:

Often taxpayers find themselves in a predicament come tax time when they discover they have not met the tests to exclude the gain from the sale of their personal residence. This is where the reduced exclusion rules come into play. 

IRS Reg1.121-3 provides a safe harbor for those taxpayers who do not meet the ownership, use, and frequency test but may otherwise qualify for the full exclusion.

The reduced exclusion calculation is based on the number of days (or months) the taxpayer meets the ownership and use requirements during the given two-year period.  This ratio, multiplied by the maximum amount allowable as an exclusion based on filing status (either $250,000 or $500,000), yields the total amount of gain that can be excluded.  
 
Employment
A change in employment may qualify for a partial exclusion if:
  • The owners were using the property as the main home when the change occurred and- 
  • The new place of employment is at least 50 miles away from the home that was sold                  

 

Health
f the sale came about because of issues centered around health, the reduced exclusion may also be available.  

 

  • Diagnosis cure, or treatment of disease, illness or injury of a qualified individual
  • Parent, grandparent, children, step-parents, grandchild, step child, in-laws, adopted children, Uncle, Aunt, nephew, niece or cousin, In-laws, sister-in law, brother-in-law
  • Doctor’s recommendation
Unforeseen Circumstances
The reduced exclusion rules may apply for facts and circumstances that are beyond the taxpayer’s control.  Some of the specific events are:
  • Involuntary conversion of home
  • Natural or man-made disasters
  • Death
  • Divorce or Separation
  • Multiple Births for the Same Pregnancy
  • A change in employment or self-employment status that results in the inability to pay reasonable living expenses
Facts and Circumstances
The courts, when deciding a decision, look at the merits of the taxpayer’s case based on facts and circumstances.  Some of the factors they take into consideration are:  
 
  • The events forcing the sale occurred while the taxpayer lived in the home
  • That the sale occurred soon after the event
  • The event was not reasonably foreseeable
  • The taxpayer’s financial ability to keep the home materially changed
  • The suitability of the property as a residence changed significantly             
 

Business or Rental Use of Home  

As generous as Congress and the IRS has tried to be by allowing the exclusion of gain by arguably a taxpayer’s most valuable asset, they are less so if the residence has business or rental use.  In any event, if there was business/rental use, any depreciation associated with the business use cannot be excluded from the taxable gain calculation. 
 
 

As with any asset, depreciation is merely a temporary deduction, which allows the taxpayer to recover the cost of the asset over its useful life for wear, tear and obsolescence.  It’s temporary because when the taxpayer goes to sell or otherwise dispose of the asset, the depreciation previously deducted on the asset is taken into back into income when performing the gain or loss calculation.  The business and/or rental use of a personal residence is no exception.

As mentioned, any depreciation that could have been taken or was actually taken cannot be excluded from the taxable gain and must be reported on the individual’s tax return as “Sec. 1250” gain taxed at the 25% tax rate.

  
How the exclusion is calculated depends where the business use portion of the residence is situated.
  
Within same dwelling unit:
No allocation of basis or amount realized if within same dwelling unit.
  • Gain is recognized to the extent of depreciation deductions allowed or allowable after May 6, 1997.
  • If taxpayer has adequate records, the amount he can’t exclude is the amount allowed (generally less than the amount allowable).             

 

  Not within same dwelling unit:  

  • Either separate structure or separate entrance with separate kitchen, bath etc. 
  • Must treat as sale of separate properties and allocate gain. 
  • Gain allocated to business portion is taxable, if exclusion rules are met; the personal portion is non-taxable. 
  • Gain and basis is allocated using the same method to calculate depreciation.

 

If you have any questions, please feel free to contact one of the CPAs in the office.  We would be more than happy to assist you.

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