In 1997, the laws that taxed the profits from the sale of your primary residence were changed. Out went the 24-month rollover replacement rule and the one-time exemption. In came a tax law that was much easier for everyone to understand: Profits up to $250,000 if you’re single ($500,000 if you’re married) are tax-free, provided you’ve lived in your home for two of the past five years and it’s your primary residence.
However, many questions remained unanswered. For example, what happens if you live in your home for only 18 months? Could you take three-quarters of your profits tax-free or could you take up to $187,500 (three-quarters of the $250,000 maximum, or up to $375,000 if you’re married)?
Recently, the IRS clarified the rule, and it may end up putting some more change in sellers’ pockets.
The IRS has provided relief to homeowners who have to sell because of a change in the owner’s health, employment or unforeseen circumstances. For example, if you sell to take a job more than 50 miles away from your current job, you can take a proportionate share of the profits from the sale of your home.
For example, if you lived in your home for a year, and then got transferred, and your home showed a profit when you moved, you could take up to $125,000 in profits if you’re single (or up to $250,000 if you’re married) tax free when you sell. You take half of the total profits available to you because you lived in the home one-half the required amount of time – one year instead of two years.
Now, sellers who sell because of death, divorce or legal separation, job loss, employment changes or multiple births from the same pregnancy, will also get some proportionate tax relief when their sale closes.
According to the IRS, if you buy a home and have to sell it six months later because your spouse died, and you will have profits from the sale of the property, you can take up to $125,000 in profits tax-free. If you lose your job and can’t find a new job quickly, and end up on unemployment and have to sell your home, you can take a proportionate share of those proceeds tax-free as well.
In another example, if your job changes, and you accept a lower salary that makes it difficult to meet your mortgage payments each month plus basic living expenses, and decide to sell, you’ll also be able to take a proportionate share of profits tax free.
If you sell because your home was damaged in a natural or man-made disaster, or the property was “involuntarily converted” to public use under a local government’s eminent domain law, you will be eligible to take a proportionate share of profits tax free.
The conditions specified must involve the taxpayer, spouse, property co-owner or a family member living in the home.
The IRS has also eased the home office deduction/recapture rule. Previously, if you claimed a home office deduction on your federal income tax form, you had to declare what percentage of your home you used exclusively for work. Let’s say you used 20 percent of your home. Under the old rule, when you sold, you would have to pay a proportionate share of tax to the IRS to recapture the deduction.
So if you had a $100,000 profit on your home, and claimed you used 20 percent of the home for work, you would have had to write a $20,000 check to the IRS. Now, the IRS says you no longer have to “allocate gain” between business and residential use if the your business was conducted inside your home.
That means, if you work above your attached garage, you don’t have to write the IRS a check when you sell. However, if your garage is detached, or you work in a separate structure even if it is on the same lot, your profits would be taxable when you sell. But keep in mind that you may still owe the IRS money from your profits if you depreciated the property. Your tax advisor can advise you further.
If you might now benefit from this change, you may be able to file an amended return for the past three years. Talk to your tax advisor about whether or not you qualify for filing an amended return, and if you should now consider the home office deduction going forward.
Clarification: In a recent column, I said that the federal government permits a first-time buyer to borrow up to $10,000 from their IRA for the purchase of a first home. But under current federal law, you may not borrow from your IRA for any reason. However, you can take a $10,000 withdrawal from your IRA for the purchase of a first home and avoid the additional 10 percent penalty. You would, however, have to pay income taxes on the cash because it is a withdrawal.