Federal tax laws permit a single taxpayer to exclude up to $250,000 of the profit on the sale of a principal residence, if the taxpayer has owned and occupied it for at least two of the five years prior to selling. The maximum exclusion for profit on sale of a principal residence is $500,000 for married couples who meet the requirements.
The ownership and use periods need not be concurrent. The two years may consist of 24 full months or 730 days during the previous five years. Short absences, such as a vacation, count as periods of use; but longer breaks, such as residing elsewhere for one year, may not.
Sometimes a taxpayer cannot meet the two-year use period because of a change in employment, health or unforeseen circumstances. Then, a taxpayer may be able to exclude a portion of the profit.
For example, a single seller who owns and occupies a home for one year and must sell the residence for unexpected reasons may exclude half the regular maximum amount, or up to $125,000 of the gain. A married couple may exclude up to $250,000 of the gain.
A sale or exchange of a residence can be considered caused by health if the primary reason for it is to obtain or speed the diagnosis, cure, or treatment of disease, illness, or injury of the owner, spouse or a co-owner whose principal residence is the same household as the taxpayer.
A sale or exchange can be considered the result of a change in place of employment if the new place of employment for the owner, spouse or a co-owner is at least 50 miles from the former place of employment. If there was no former place of employment, the distance between the new place of employment and the residence must be at least 50 miles.
The profit on the sale or exchange of a residence, within two years, may also be partially excluded by unforeseen circumstances. Examples of unforeseen circumstances include condemnation by a government agency or natural or man-made disasters that result in casualty to the residence. Other examples are death, unemployment, inability to pay housing costs and reasonable basic living expenses, divorce or legal separation and multiple births resulting from the same pregnancy.
A question often asked by widow or widowers is whether they should give their residence to a child to avoid the need to later probate this asset.
It is important to understand that giving a residence during the parent's lifetime will result in the child's assuming the parent's basis for income-tax purposes. This would be the parent's purchase price if the parent made no permanent improvements. If the parent paid only $50,000 for the residence at least two years before giving the home to the child, and the child then sold the residence for $250,000, the child will recognize a capital gain of $200,000, less any gift tax previously paid by the parent for the transfer of this property. The reason this gain is taxed to the child at capital-gains rates (and not a higher ordinary income tax rate) is because the parent owned the residence for more than two years.
This capital-gain income tax could be avoided if the parent retains a life estate in this residence and conveys only the remainder interest to child. Under the current income-tax law, the son or daughter will take a step-up in basis in the home at the parent's death, provided the parent still owned the life estate at death.
The son or daughter's basis in the residence will then be its fair market value at the date of the parent's death. If the son or daughter sold the residence after the parent's death for $250,000, and the fair market value of the residence at the parent's death was $250,000, there would be no recognition of gain and no income tax owed by the child. It is important to know that this step-up in basis provision will be repealed in 2010, along with the repeal of the federal estate tax.
The income tax effects of selling a residence are significant. A person intending to sell a residence should seek the advice of a certified public accountant or a real estate attorney.
Gregory G. Gay is a lawyer who specializes in elder law in Pasco, Hernando and Citrus counties. Write him in care of Seniority, St. Petersburg Times, P.O. Box 1121, St. Petersburg, FL 33731.