YOUR HOME, YOUR CASTLE, YOUR MONEY

By this point in time, most people know that they are entitled to a $250,000 exclusion from the gain realized on the sale of their primary, principal residence. The exclusion is $500,000 for married couples. For example, if you purchased your house for $100,000 and sell it for $250,000 – you wouldn’t pay any tax on the $150,000 in gain realized on the sale, since you are entitled to exclude up to $250,000 of gain realized on the sale of your house.

The requirement that you purchase a house of equal or greater value with the proceeds realized from the sale of your existing home no longer applies. This relatively new law – enacted in 1997 – may be a contributing factor to the tremendous run-up in housing prices.

For instance, unlike stock, the gain on which is subject to tax at ordinary income tax rates, a 20% capital gains tax rate, or an 18% capital gains tax rate, depending upon the date you purchased the stock and the duration of time for which you owned the stock – the gain realized on your house might avoid income tax all together. A tax-free windfall.

Think about the advantages that this simple provision in our tax code has provided to so many taxpayers in our area. In the past five years, housing prices in Monmouth and Ocean Counties have risen approximately 75%. That increase is incredible, to say the least. If you bought and sold two houses in the past five years, each for $150,000, you could have easily doubled your money, tax-free.

The ability to exclude $250,000/$500,000 of the gain realized on the sale of principal residence offers strong incentive for individuals to invest their money in their home. But how do you qualify for the exclusion?

In a previous column, I discussed some of the more basic requirements of the law: that the home must have served as the taxpayer’s principal residence for two of the five years immediately preceding the sale and that the exclusion will not apply if the taxpayer applied the exclusion to another sale during the two-year period ending on the date of sale of this residence, i.e., the “once every two year” requirement.

On December 24, 2002, the Internal Revenue Service published a final regulation relating to the $250,000/$500,000 exclusion rule. In many aspects, the final regulation clarifies issues regarding the availability of the exclusion.

For instance, the IRS has made it clear that the exclusion can be applied on a pro-rata basis if the taxpayer sells his home before the full, two-year use requirement is met. In other words, if a taxpayer uses a residence as his principal residence for 18 months – 6 months shy of the two year requirement – he can apply a pro-rata portion of the $250,000 exclusion to the gain realized on the sale of his home.

The final regulation also establishes criteria for determining if a residence is a taxpayer’s “primary residence.” A person could have two or more houses, so before the final regulations were published, it was unclear in such situations which house would qualify as the taxpayer’s “principal residence.” The regulation states that “the property that the taxpayer uses the majority of the year ordinarily will be considered the taxpayer’s principal residence.” So, in other words, if a person lives in a house for six months and one day, that residence is his “principal residence.”

Lastly, the regulation clarifies the availability of the exclusion when the taxpayer uses the residence for “mixed use.” For instance, assume that the person lives in a house but also rents a portion of the home to a third-party. In Red Bank, there are many two-family homes, the title to which is vested in one deed. If the taxpayer sells the house, is he entitled to apply the $250,000 exclusion to the entire house or only the half in which he lived?

The regulation states that if the mixed use occurred in the same “dwelling unit,” the exclusion can be applied to all of the property. If the mixed use occurred in a separate dwelling unit on the property, then the exclusion must be apportioned.  In other words, if there is only one house on the property, the exclusion applies to the entire property; if the rental property is a second house on the same parcel of land, then the exclusion must be apportioned.