September 4, 1997

After the capital gains tax cut, the biggest news in the Taxpayer Relief Act of 1997 is probably the new home sale gain exclusion rule. The family home is usually one of largest community assets in a divorce and as such had to be sold in order to make an equal division. In the past, this caused significant tax problems.

As you know, the old rules covering principal residence sales allowed two ways to avoid being taxed on gains. First, you could defer the gain by purchasing—within two years—a replacement residence costing at least as much as the one you just sold. The gain from the first home was then "rolled over" into the new residence. Second, if you were age 55 or over you could exclude gains up to $125,000 on a once in a lifetime basis. In most cases, sellers were able to avoid current federal income taxes via the rollover rule or the $125,000 rule, or a combination of both.

The new gain exclusion rule will allow the vast majority of home sellers to completely avoid federal income taxes on gains without having to reinvest sales proceeds in replacement houses. This will free up more money in a property division with no taxes or restrictions for reinvestment.

For sales of principal residences after May 6, 1997, gains up to $500,000 are completely tax-free for married couples who file joint returns. The limit is a still-generous $250,000 for single and married filing separate status. The new provision replaces both the old-law gain rollover rule and the $125,000 exclusion for seniors.

This break can be "recycled" every two years. For purposes of the two-year rule, sales before May 7, 1997 don't count against you. For example, if you sold your previous home in August of 1996, you would be fully eligible to use the new gain exclusion rule if you sell your present house next month. If you have two sales after May 6 1997, failure to meet the two-year rule doesn't completely shut you out of your exclusion—as long as the second sale is forced by a job change, health reasons, or other unforeseen circumstances as defined by the IRS in regulations to be issued at a later date. In this situation, the normal gain exclusion limit is prorated based on the actual period between the sales and two years. For example, if a single person has two sales that are only one year apart due to a job transfer, the maximum gain exclusion for the second sale is $125,000, or half the normal amount [$250,000 ´ (1-year holding period ¸ 2-year requirement)]. For sales occurring before August 5, 1999, you are generally entitled to use a pro rata portion of the gain exclusion even if the sale is not because of a job change, health reasons, or other unforeseen circumstances (as defined by the IRS) and even though you fail to meet the two-out-of-five-year ownership and use test discussed in the next paragraph.

To qualify for the exclusion, the home must have been owned and used as your principal residence for at least two years out of the five-year period ending on the sale date. This will help the out spouse during the divorce process to qualify for this tax relief. However, the exclusion doesn't apply to the extent of any depreciation claimed after May 6, 1997 (for example because you depreciated an office in the home or rented the house for a period of time). For homes acquired in transactions where gain from selling a previous home was rolled over to the current residence, ownership and use of the prior residence are counted for purposes of meeting the two-out-of-five-years test.

When a couple gets married and they own separate residences, they are each entitled to a $250,000 gain exclusion, assuming the other qualification rules are met by each person for each home. For example, if the couple moves into the husband's home, the wife can sell her house and exclude $250,000 as long as she owned it and used it as her residence for at least two out of the five preceding years. The couple can then decide to sell the husband's home. He will also be eligible for the full $250,000 exclusion if he meets the same test, even if his sale occurs less than two years after the wife's transaction. The same would be true if the wife sold her home and excluded the gain shortly before the marriage. If the couple chooses to reside in the husband's home, they become eligible for the $500,000 joint-filer exclusion when more than two years have passed since the wife excluded gain from the sale of her former home.