Tax Guru-Ker$tetter Letter
Tuesday, December 24, 2002
Residence Sale Rules
In May 1997, over five and a half years ago, the rules for tax free sales of primary residences were changed dramatically. There are still many people, including quite a few real estate and tax professionals, who believe we still have the old rules requiring that a new more expensive replacement residence be purchased.
As with most tax laws, our rulers in DC like to use a lot of vague terminology and expect the geniuses at the IRS to fill in all of the details as to how the law should be implemented in real life. In typical government fashion, IRS is rarely in any hurry to work on these matters, especially in cases such as this, where people are legally allowed to avoid paying taxes.
As I outlined in my explanation of the current residence sale rule, there were some cases where the seller didn't have to actually live in the home for a full two years in order to exclude part or all of his/her gain. The reasons were very vague: employment, health or other unforeseen circumstances. What exactly qualified as meeting those conditions was left up to IRS to define. In the meantime, we in the real world had to decide how to handle tax returns for real people.
This is one of many areas in taxation where there is a big difference between the attitude of tax professionals. Unfortunately, you would think that most tax advisors actually work for IRS in how they deal with this. I occasionally check out online tax Q & A discussion boards and am amazed at how willing supposedly independent tax advisors are to side with IRS.
IRS has the benefit of being able to take its sweet time interpreting the tax laws. In the meantime, those of us living in the real world have to conduct our lives. We can't put everything on hold waiting for IRS to decide.
This state can be dealt with in two ways. We can refrain from our own interpretations of the tax laws until IRS issues its formal pronouncements or we can do our best to interpret the law. Unfortunately for most taxpayers, the majority of tax professionals choose the former approach.
My approach to this situation has always been the complete opposite. My interpretation is that if IRS has not come out and definitively stated how something should or shouldn't be treated for tax purposes, they have no right to dispute our reasonable interpretation of the fuzzy gray areas in tax law. They can't come in after the fact and claim that we did it wrong if they refused to tell us ahead of time how to do it right. I have been doing this for almost 27 years, and continue to take this approach, and I have yet to have any of my interpretations overturned by IRS. There are occasionally IRS personnel who may try to use a proposed IRS regulation to bolster their argument. When I point out to them what the word "proposed" means, they always back down.
For those tax advisors whose loyalties lie on the side of the IRS, the IRS goal of avoiding tax saving steps is achieved just by their delays. For those of us who believe in doing everything we can to help clients, the delays help our case.
Back to home sales. IRS has finally released their official safe harbors for defining the terms of the 1997 law in regard to such matters as proper occupancy, mixed use (business and personal) property, land sold separately from the main home, as well as how to qualify for the pro-rated exclusion under the employment, health and unforeseen circumstances tests. Again, while many tax practitioners will use these IRS examples as the definitive list of what are acceptable reasons, that is not the case. They are merely safe harbors. This means that IRS will not disallow the tax free exclusion of gain by anyone meeting their examples. It does not mean that other reasons not included in their examples won't qualify under the normal facts and circumstances test.
In the IRS pronouncement, they mention that anyone who paid tax on a gain that now falls under one of the tax free safe harbors can amend his/her 1040. However, because the statute of limitations for modifying tax returns is only three years, only 1999, 2000, and 2001 1040s can legally be amended. Anyone who erroneously reported taxable gain on their 1997 or 1998 1040 is out of luck.
For those who want more details, here are some handy links:
IRS announcement of new rules
IRS three page pdf summary of safe harbors
IRS 22 page pdf of temporary regulations re: pro-rated exclusion
IRS 48 page pdf of final regulations re: tax free residence sales
My summary of the IRS summary in easier format.