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 Exclusion of gains

Exclusion of gain on personal residence

Individuals are permitted in certain cases to exclude from taxable income upto $250,000 of gain ($500,000 in general for married couples filing joint return) realized on the sale or exchange of property that has been used as a principle residence. The exclusion does not apply to any gain attributable to depreciation deductions taken in connection with the rental or business use of the property for periods after May 6th 1997,
To qualify, the tax payer must have owned and used the property as his or her principle residence for atleast 2 years during the 5 year period ending on the date of the sale or exchange. The exclusion is allowed each time a tax payer sells or exchanges a principle residence, meets the eligibility requirements, but generally no more often than once every 2 years. A tax payer is entitled to a prorated amount of the exclusion if he or she fails to meet either of the 2 year requirements by reason of a change in place of employment, health or other unforeseen circumstances. In such case, the amount of exclusion the tax payer is entitled to is a ratio of the amount that would have been allowed if the 2 year requirement had been met.
The new law repels the rollover rules that have allowed tax payers to defer the gain on a sale or exchange of a principle residence to the extent that the proceeds of the sale are applied to a replacement residence within 2 years. It also repels the once-in-a-lifetime $125,000 exclusion on sale of principle residence for tax payers age 55 and over.

Example: Mr. & Mrs.Jones purchased and occupied a principal residence in City A in 1998.Exactly one year later,  Mrs.Jones is transferred by her employer to City B and the Jones family moves.They sell their home for a $200,000 gain.Because the time the Jones family spent in the residence is only one-half of the required two years, the amount of gain they would be eligible to exclude is limited to one-half of the amount otherwise allowed, or $100,000.
The $500,000 exclusion applies to married couples filling a joint return where either spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse has had a sale in the preceding two years subject to this exclusion. Married couples filling a joint return who do not share a principal residence are each entitled to an exclusion of $250,000.A single taxpayer who marries a taxpayer who has used the exclusion within two years prior to the marriage would also be allowed a $250,000 exclusion.Once both spouses satisfy the eligibility requirements and two years have passed since the last exclusion was allowed to either spouse, a full $500,000 exclusion would be available for the next sale or exchange of their principal residence.
Many other special rules apply, including:

  • A taxpayer can elect not to have the exclusion apply to any sale or exchange.
  • Certain periods an individual resides in a nursing home on account of physical or mental incapacity are included as part of the two-year requirement if certain other rules are met.
  • An individual whose spouse is deceased on the date of the sale of the property can include the period the deceased spouse owned  and used the property before death.
  • An individual is treated as using property as his or her principal residence during any period of ownership while the individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument.
  • In case of stock held as a tenant-stockholder in a cooperative housing corporation, the ownership requirement applies to the holding of such and the use requirement is applied to the house or apartment the taxpayer is entitled to occupy as a stockholder.
  • The new exclusion is effective for sales or exchange after May 6, 1997.However, a taxpayer may elect to be subject to the old rules(i.e. the rollover and $125,000 exclusion provisions)if:
  • the sale or exchange occurred prior to August 5, 1997;
  • the sale or exchange occurs after August 5, 1997, but is pursuant to a binding contract in effect on that date; or
  • no gain on the sale would be recognized, under the prior-law rollover rules, on account of a replacement residence that was acquired on or before August 5, 1997(or pursuant to a binding contract in effect on that date).
    Where a taxpayer acquired his or her residence in a transaction covered by the prior rollover rules, the periods of ownership and use of the prior residence are taken into account in determining ownership and use of the current residence.
    Taxpayer who own property on August 5 , 1997, and sell the property before August 5, 1999, but fail to meet the ownership and use requirements to otherwise qualify for an exclusion, can use the pro ration rule to qualify for a pro rated exclusion based on the period they did own and use the property.

Observation:Taxpayer who have gain on the sale of their principal residence in excess of the $250,000/$500,000 limits of the new exclusion and who meet one of the tests of the transition rule to elect not to apply the new rules should consider taking advantage of the old law’s rollover provision if they are replacing their old principal residence with a new one, as long as the cost of the new residence is more than the allowable exclusion under the new law.

Example:Mr.& Mrs. Smith sell their house, which they purchased 40 years ago for $500,000, for a sales price of $ 6 million, after May 6, 1997, but prior to August 5 1997.Under the new law, the Smiths would be taxed on $ 5 million of gain($6 million less $500,000 basis less $500,000 exclusion).Assuming the Smiths replaced their residence with a new one costing more than $1 million, they would be better off electing to be taxed under the old rules.


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