Capital Gains Tax Exclusion Loopholes

     If you’re like many people, as soon as anyone starts talking about tax exclusion
loopholes, your eyes start to glaze over. You’re interested in saving money, certainly, but the idea of learning the details of tax law makes you want to run the other direction.
     So, I’m going to boil it down: One of the most powerful tax benefits available to
homeowners is the principal residence gain exclusion. It can shield a substantial portion
of your home sale profits from federal capital gains tax.
     When you sell your primary home, the IRS allows you to exclude up to $250,000
of capital gains from your taxable income if you’re an individual, or up to $500,000 if
you're married and filing jointly. To qualify, you generally need to have owned and lived
in the home as your primary residence for at least two of the last five years preceding
the sale. If the proceeds from the sale fall within those thresholds, you may owe nothing in federal capital gains tax.

What If You Have to Sell Early?
     Life doesn't always cooperate with the two-year requirement. Job changes, health issues, and unexpected circumstances force people to sell homes before they've met the full ownership and use threshold. The good news is that you may qualify for a prorated exclusion.
     If you have a qualifying reason to sell early, here’s how it would work: you simply
multiply the full exclusion amount by the fraction of months you owned and used the
home divided by 24. So, a married couple who owned and lived in their home for 11
months could still exclude roughly $229,000 in gains (not the full $500,000, but still a
significant savings).

Three Qualifying Reasons for Early Sale

     The tax code recognizes three main categories of hardship that justify a prorated
exclusion when the two-year threshold hasn't been met:
     1. Employment changes: If a new job requires you to relocate and your new
workplace is at least 50 miles farther from your former home than your old workplace
was, you likely qualify. This applies to both employees and self-employed individuals.
Even if you don't quite clear the 50-mile threshold, you may still qualify if the facts clearly show the move was employment-driven (for example, if you’re an ER doctor who has to live within ten miles of the hospital where you work).
     2. Health reasons: Sales prompted by medical needs, yours or a “qualified
individual’s,” can get you the prorated exclusion. Qualified individuals include people such as your spouse, co-owners of the property you’re selling, household members, and a wide range of relatives. Conditions ranging from being close to a hospital that provides specialized care to a parents dementia would be valid health-related reasons.
     3. Unforeseen circumstances: Events that couldn't reasonably have been anticipated when you purchased the home may also qualify. The IRS has established a
list of safe harbor situations: natural disasters, acts of terrorism, death of a qualified individual, job loss that triggers unemployment eligibility, divorce, and multiple births from a single pregnancy, among others. Beyond these defined events, other genuinely unforeseeable situations may still qualify based on the specific facts involved.
A Note on Business or Rental Use
     If part of your home has been used for a business or rented out, the picture gets
more complicated. Generally, if the business space is within the same dwelling unit
(within the same four walls), the entire property can still qualify for the exclusion.
However, any depreciation you've claimed on that space after May 6, 1997, must be
recaptured as taxable income when you sell, at a maximum rate of 25%. If the business use involved a completely separate structure on the property, such as a detached office or studio, that portion may not be sheltered by the exclusion at all.
The Bottom Line
If you sell your house before having lived in it for two years, chances are you
won’t be making a profit big enough to worry about, but if you meet the criteria above, you may be spared from paying any capital gains tax on the proceeds from your home sale. Remember, everyone’s situation is different, so consult with your tax professional before making any final decisions.
      If you have questions about property management or real estate, please contact
me at [email protected] or call (707) 462-4000. If you have an idea for a future
column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s
Bakery.
     Dick Selzer is a real estate broker who has been in the business for more than
50 years. The opinions expressed here are his and do not necessarily represent his
affiliated organizations.