In 1997 there were changes made to the tax law regarding the taxation of gains on the sale of a personal residence. Now, the Internal Revenue Service has issued regulations that clarify those 1997 changes. The tax rules now in effect are much more favorable for taxpayers who take the home office deduction on their tax returns.
Previously, taxpayers were required to prorate the gain on the sale of a house between the business and the non-business portion of the home and pay tax on the business portion of the gain.
Under the new regulations, taxpayers no longer have to prorate gain between business and non-business portions of their home but instead are only required to pay tax on the gain equal to the amount of depreciation claimed after May 6, 1997. Any additional gain on the sale of the home is non-taxable, up to the maximum exclusion of $250,000 for single homeowners and $500,000 for joint homeowners.
What is especially important to note is that these rules are retroactive. Because the rules clarify law that was made effective in 1997, the new rules are retroactive to 1997. However, for most taxpayers, transactions made in 1997 and 1998 are already closed to change due to the three-year time limit for amending tax returns.
Any taxpayers who sold a home after 1999 should examine the tax treatment of the sale and consider amending if a home office was involved. Tax returns from 1999 may be amended until April 15, 2003 (or three years after the filing date of the 1999 tax return if it was after April 15, 2000). After that date those tax years will be closed.
Tax preparers should go back over their clients' records for the past three years to determine if any changes are necessary as a result of these new regulations. Use IRS Form 1040X, Amended U.S. Individual Income Tax Return, to make changes to federal returns, and be sure to check the rules for amending in your state as well.