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Plan carefully before you jump through this loophole

To any homeowner whose plan for retirement includes a move from one residence to another, a special item in the U.S. tax code looms very large.

For want of a catchier name, it's called the "onetime exclusion of gain for people age 55 or older," in the words of the Internal Revenue Service document (Form 2119) that is used to report home sales.

It permits people who fit that age requirement to cash in up to $125,000 in profits from the sale of a home without having to pay capital gains taxes.

But nobody is allowed more than one passage per lifetime through this loophole, and its benefits can be diminished or lost entirely if the trip isn't carefully planned.

The idea behind the exclusion is to allow people who have built up a substantial amount of equity in a home over the years to convert some of that asset into a more liquid form as they reach or approach retirement.

Suppose, for the sake of illustration, that you and your spouse own a home bought years ago for $50,000, and now worth $225,000. The kids are grown, and you want to sell the old homestead and move into a smaller place that's on the market for $100,000.

If neither you nor your spouse is 55 years old yet, the change of address will leave you with a $125,000 gain on which you will have to pay federal income taxes of as much as $35,000.

But if either of you has passed your 55th birthday by the time you sell the old house, and you elect to take the exclusion, you won't owe a penny to Uncle Sam. The extra $35,000, if invested in a bond paying 7 percent a year, can mean a difference of more than $100 a month in your cash flow.

It's important to be aware that the rules covering this process are complicated but inflexible. If you make a misstep somewhere in following them, it's easy to trip yourself up.

First of all, tax experts say, make sure you meet the eligibility tests for the exclusion before you sell. In addition to the age minimum, you must have owned and lived in the old home for at least three of the five years preceding the sale.

"Don't make the mistake of selling your residence in the year you become 55 but before your 55th birthday," cautions the Ernst & Young Tax Guide.

In addition, many people who are eligible, but have only a relatively small exclusion they can claim, have to decide whether to take it now or forgo it, expecting that they might have a bigger gain to exclude sometime in the future.

If you have, say, just $10,000 to exclude on a current transaction, that will use up your lifetime eligibility. You cannot save the other $115,000 for some future deal.

Also, common life events like divorce, widowhood, marriage or remarriage can bring many additional variables into your calculations.

For example, suppose you and another person, both divorced and over 55, are planning to marry soon.

"If both individuals own homes, they should decide what to do with the residences and then take action BEFORE the wedding," says the accounting firm of KPMG Peat Marwick in its newsletter, Financial Independence.

"Before marriage, both individuals would be entitled to the age-55-and-over exclusion. After marriage, they would be allowed only one exclusion between them."

Peat Marwick concludes: "For taxpayers whose homes seem to hold more memories than family members, or where everyday maintenance is straining the taxpayer's patience and financial resources, trading down may be a prudent strategy. The age-55-and-over exclusion provides an added incentive."