Sale of Real Estate - Capital Gains Exclusion

Final Rules on Capital Gains

The Internal Revenue Service has issued its final rules on the capital gains tax exclusion that is available on the sale of a taxpayer's principal residence.  A taxpayer may exclude up to $250,000 from the sale of a principal residence, and the exclusion doubles to $500,000 for married taxpayers.  However, the taxpayer must have owned and used the property as a principal residence for a total of at least two of the five years before the residence is sold.

The final rules focus on the part of the Internal Revenue Code that allows a tax payer who fails to meet the above condition to still have an exclusion in a reduced amount.  There are three grounds for claiming a reduced exclusion:  change in employment, health, and unforeseen circumstances.  For each of these grounds, the regulations provide a general definition and one or more "safe harbors" specific reasons for the sale of the residence.  If the safe harbor for a particular ground applies, a sale (or exchange) is deemed to be "by reason of" that ground.  If no safe harbor applies, the taxpayer still can claim one of the grounds on the basis of all of the surrounding facts and circumstances.

For example, the safe harbor for claiming a reduced exclusion because of a change in employment applies when the new place of employment is at least 50 miles farther from the residence that was sold than was the former place of employment.  As for health, the safe harbor that smoothes the way for the reduced exclusion is a physician's recommendation of a change of residence for reasons of health.  A sale or exchange of a residence due to unforeseen circumstances refers to the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence.  Simply wanting to move to a preferred home or moving due to improved financial circumstances does not qualify.  The specific events that make up the safe harbor for this ground include, among other things, such circumstances as death, divorce, natural or man-made disasters affecting the house, and even multiple births from a single pregnancy.