More on the sale of residence exclusion rules gain exclusion requirements

Taxpayers who sell or exchange a principal residence after May 6, 1997 can exclude up to $250,000 on a single return or up to $500,000 on a joint return of realized gain. A residence includes houseboats, trailers, condos, and coops. Gain is computed by subtracting from the gross sales price the selling expenses, cost of improvements, and adjusted basis or original cost which is reduced by any previously deferred gain.

Taxpayers must meet three tests to qualify:

The taxpayer must have owned the residence for at least two of the last five years ending on the date of sale. In the case of a couple living in the residence, only one taxpayer/owner needs to meet the test.

The taxpayer(s) must have used the residence for at least two of the last five years ending on the date of sale. Both occupants must meet this test, but the time does not have to be consecutive.

The taxpayer(s) must not have used the $250,000/$500,000 exclusion for any residence sold or exchanged during a two year period ending on the date of the current sale or exchange. This test does not apply if the first sale or exchange occurred before May 6, 1997.
 
Effect of filing status on exclusion

If only one spouse meets the use test, a $250,000 is still available.If a single taxpayer marries a taxpayer who used the exclusion within two years of marriage, the $250,000 exclusion is still available to the spouse who did not have a sale or exchange transaction within two years. A husband and wife who married with each owning a residence would be able to exclude $250,000 for each of the two residence sales, provided they met the ownership and use tests.

 
Periods in a licensed care facility

Periods of residence in a licensed care facility count towards the use test as if the taxpayer(s) were actually living in the residence. However, the taxpayer must actually occupy the residence for at least one year. Taxpayers who are in this situation should be aware that their exclusion will be lost if they don¯t sell their residence within the five year period. 
PARTIAL GAIN EXCLUSION
If taxpayers have sold more than one residence within the two year period, they may be entitled to a partial exclusion if (quoting from IRC Section 121(c)(2)(B)

"......such sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances."

The partial exclusion is based on a fraction, the numerator of which the shorter of:

The lesser of the aggregate amount of time during the five year period ending on the date of sale or exchange that the taxpayer either (a) owned the residence or (b) used it as his or her principal residence, or

The amount of elapsed time since the taxpayer last used the exclusion.
The denominator is 730 days, the numerator is also computed in days, and this fraction is applied to the exclusion, not the gain.
 
Divorce situations

If one spouse transfers his or her ownership to the other spouse taxfree under Section 1041 pursuant to a court order, decree, etc., then the tranferee spouse¯s period of ownership shall include the period the transferor owned the residence. Note that this exception only applies to the ownership test.

If one spouse must leave the residence pursuant to a divorce decree or separation agreement but continues his or her ownership, that spouse is considered to be using the residence for the period the other spouse is granted use of the property under the decree or separation agreement.
 
Death of a spouse

If a spouse dies and the surviving spouse does not meet the ownership and or use test, the surviving spouse may "step into the shoes" of the deceased spouse¯s ownership and use periods. NOTE: the residence may receive a step-up in basis for some part or all of it under estate tax rules, due to the deathof the spouse.

Business use

The fact that a residence is rented or being used as a home office does not automatically gain attributable to such business use from being excluded. Rather, the exclusion cannot be claimed to the extent depreciation was allowed for periods after May 6, 1997. In addition, the exclusion cannot be claimed if the ownership and use tests were not met with respect to the portion of the property that is either rented or used as a home office. What the new law does change is that even if the house was rented, the gain can be excluded (except for depreciation allowed) if the ownership and use tests were met.

Example: Joan purchased a two family residence on July 1, 1996. She rented 0% of the house until December 31, 1998. In May 2001 she sells the house. Joan had taken $10,000 in depreciation. Joan would be able to exclude all but $10,000 of gain because she used the rental portion for two years or more.NOTE: Most rental situations will not qualify because the two year use test will not have been met, generally speaking.
Most home office situations would probably not meet the use test either, but there is an opportunity to cure the problem if the businessowner moves to an outside office and uses the former home office as residential space for at least two years.