Divide and Conquer: A Partial Home Sale Exclusion
In the tax world, part of a loaf is usually better than no loaf at all. For instance, if any of your clients don't qualify for the home sale exclusion because they don't meet the time requirements for "ownership" and "use" of a principal residence, a partial exclusion still might be available. This could be worth literally hundreds of thousands of tax dollars on a client's tax return.
Here's a brief recap: Under section 121 of the tax code, a single filer can exclude from tax the first $250,000 of gain from the sale of a home, while joint filers can double the exclusion amount to $500,000. However, to qualify for this enormous tax break, the taxpayer must have owned and used the home as a principal residence for at least two out of the previous five years. There's no limit on the number of times you can claim the exclusion.
What Can You Foresee?
According to the applicable IRS regulations, the following events are considered to be "unforeseen circumstances" for purposes of the home sale exclusion.
- Loss of employment.
- A job change reducing the ability to pay for the home.
- Multiple births from the same pregnancy.
- Damage from a disaster.
- Taking of property.
If any of these conditions apply, your client should be able to claim a partial exclusion for ownership and use of the home for less than two years.
Normally, it's relatively easy to stick around long enough to meet the requirements, but sometimes life gets in the way. At least it's not an all-or-nothing proposition. The tax law allows a home seller to claim a partial exclusion if the sale results from a change in employment, a need for medical care or other "unforeseen circumstances" (see sidebar).
If none of these conditions apply, the window of opportunity is still open a crack. The IRS will examine the circumstances of each case, focusing on factors such as whether the home has become less suitable as a principal residence, if the taxpayer's ability to pay for the home has been materially decreased and if the sale could have been reasonably anticipated when the home was acquired.
Assuming a taxpayer qualifies, how much is the partial exclusion? It's based on the available exclusion amount multiplied by the applicable ratio under the ownership and use test.
Let's look at a typical example. John and Jane Smith have owned and used their home as their principal residence for nine months. But John's employer is transferring him to another branch halfway across the country. So the Smiths put their home on the market and quickly sell it at a $200,000 gain.
Even though the couple hasn’t stayed in the home for the minimum two years, they still qualify for a partial exclusion. Under these facts, they can exclude from tax a maximum of $187,500 from the home sale [$500,000 x (9 months divided by 24 months)]. The remaining $12,500 of the gain ($200,000 - $187,500) is taxable under the capital gain rules.
The IRS provides a worksheet for computing a partial exclusion in Pub. 523, Selling Your Home.