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Taxpayer Locked Out of Partial Home Sale Exclusion

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Getting just a piece of the pie is better than no pie at all, especially when it comes to net returns on a home sale.  But as a recent Tax Court case showed, meeting basic requirements is everything.

May 16th 2022
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Taxpayers who don’t qualify for the full home sale exclusion may be entitled to claim a partial tax exclusion in certain situations. However, as shown in a new case, Webert, TC Memo 2022-32, 4/7/22, you still must satisfy the bare minimum requirements. 

 

Basic premise: When you sell your home, you may be able to exclude from capital gains tax the first $250,000 of gain if you’re a single filer or $500,000 for joint filers.

To qualify for this exclusion, you must have owned and used the home as your principal residence for at least two out of the previous five years. Generally, you can’t claim any exclusion if you don’t meet these two tests or you’ve claimed the exclusion within the last two years.

However, if you sell the home without meeting the two-year requirement or if you’ve claimed the exclusion within the last two years, you still may be in line for a partial exclusion. This tax break is allowed if you sell the home due to a change in employment, a need for medical care or other unforeseen circumstances.

The IRS has approved a partial exclusion in several exceptions involving “unforeseen circumstances.” If none of these exceptions apply, the IRS will examine the particular facts and circumstances.

Facts of the new case: The wife of married couple purchased a home in a Seattle, Washington suburb in 2005. In the same year, she was diagnosed with cancer, for which she had extensive surgery. The couple lived in the home until 2009. They got divorced in 2016.

The wife’s heath issues immediately led to financial challenges. She required more money to pay for mounting medical bills. Also, her health conditions reduced her working capacity permanently, which contributed to an extended period of financial hardship.

To alleviate their situation, the wife put up their home for sale. However, the financial and housing markets crashed in 2008. The fallout was especially bad in the Seattle area. Therefore, the couple eventually rented out their home to tenants. Apparently, they lived full-time in another nearby residence.

The wife sold the house on October 20, 2015, for $1.14 million and realized $194,752 of long-term capital gain pursuant to the sale. In sum, she owned the property for roughly 11 years (2005-15), of which she used it as her principal residence for five years (2005-09) and then as rental property for six years (2010-15).

The wife claimed a partial home sale exclusion for this primary residence. She argued that the sale was due to the unforeseen circumstances of the crash in the financial and housing markets. Alternatively, she attributed the sale to health reasons. But the IRS disagreed with her reasoning and issued a notice of deficiency,

Tax outcome: The Tax Court determined that the couple’s claims are a moot point. They didn’t own or use their property for any of the five years prior to the sale. Accordingly, they are not entitled to any exclusion.  

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