Question

Discuss the how residence sales are treated under the tax law. You may want to refer to Section 121 of the tax code and to the IRS publication 523.   What are the requirements for it to qualify as a "residence" sale?   What are the limitations?   Why does the law provide this benefit to taxpayers? What if the taxpayer has more than one home, can 2 or more homes qualify?   What is the 2-year rule all about?

Answer 1

Ans: 2-year rule: A house, houseboat, mobile home, cooperative apartment, or condominium can be a principal residence. To qualify for the tax exclusion, you must satisfy both the ownership and use requirements—you must own the principal residence for at least two of the five years before the sale or exchange and live in it for at least two of the five years. The two years need not be continuous. (The use requirement is met if you lived in the home the first and fourth years, for example.) Short absences from your home are ignored. For example, a two-month summer vacation is treated as time lived in your principal residence. But a one-year absence is too long. Time spent in your home by your son, daughter, or other family member doesn’t count either. If you have two or more homes, the one used the majority of time in a year is treated as your principal residence, unless you can showotherwise. You can be living elsewhere when you sell your home if the two-year test is met. If you alternate between two properties, using each as a residence for successive periods of time, the property that you use for a majority of the time during the year will ordinarily be considered your principal residence.

To qualify as a "residence" sale you must use the property as your principal residence for a total of two years, not necessarily consecutive, out of the five years preceding the sale. Only one sale or exchange every two years is permitted, but sales prior to May 7, 1997, do not count.

Limitation:

Ownership
Only one spouse needs to own the home, but both must have lived there two years to qualify for the joint filing $500,000 exclusions. For divorced or separated spouses, if either meets the two-of-five test and one lives there by court order, each can exclude $250,000. If a residence is transferred to a taxpayer as a result of a divorce, the time during which the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership. A taxpayer who owns a residence is considered to be using it as a principal residence while the taxpayer’s spouse or former spouse is given use of the residence under the terms of a divorce or separation. There’s a break for sales due to job changes, bad health, or unforeseen circumstances, even if the two-year residency test isn’t met. The percentage of the $500,000 or $250,000 exclusion that can be claimed depends on the fractional part of the two-year period that the home was owned.

Home Office Deduction
If a portion of the principal residence is used as a home office (you have taken a home office deduction on your tax return), the exclusion does not apply to the portion of gain that’s attributable to the home office. If no home office deduction was claimed for at least two of the previous five years, you qualify for the full exclusion (provided ownership and use tests are satisfied). If the office space was not used for residential purposes for two years in the five years before the sale, the gain on the office portion is taxed.

For example, suppose a single tax payer owned and lived in the principal residence for the past five years and sold it in 1998 for a $300,000 gain. The full amount of the gain exclusion applies—$250,000 of the gain would not be subject to the federal tax. The remaining $50,000 gain is subject to the capital gains tax (20% for property held more than 12 months). After two years, the single taxpayer can exclude up to $250,000 of the gain on the sale of another residence.

For married taxpayers to qualify for the full $500,000 exclusion, both spouses must live in the home for at least two of the five years preceding the sale or exchange, and neither spouse could have used the exclusion during the previous two years.

Only one spouse, however, must meet the two-year ownership test. If only one spouse meets both the ownership and use requirements, the $250,000 exclusion for a single taxpayer is available for the qualifying spouse (even if the other spouse used the exemption within the past two years).