Safety Net Can Protect Against Capital Gains Tax

WASHINGTON--The biggest unanswered question facing American homeowners at tax time this year might strike you as odd: What is an “unforeseen circumstance” and how can you claim one to avoid capital gains taxes on a profitable home sale?

That question has been pending before the Internal Revenue Service for more than a year with no answer in sight. Yet the issue has potentially large financial significance for anyone who has resold a home at a profit after occupying it for less than two years.

Here’s what’s involved: You probably know that under tax reform legislation enacted in 1997 and 1998, you can exclude from taxation up to $250,000 (as a single filer) or up to $500,000 (if married filing jointly) of profits on the sale of your home, provided you owned and used it as a principal residence for at least two of the five years preceding the sale. For the vast majority of American homeowners, the law renders home sale profits totally tax free.

But many sellers find themselves in situations that disqualify them for the strict tests of two years’ ownership and two years’ use. For them, Congress provided a safety net. Taxpayers who sell before the required two-year period because of a change in place of employment, a change in health or because of unforeseen circumstances can qualify for what Congress called a “reduced exclusion.”

Taxpayers who cannot claim employment change, health change or unforeseen circumstances in connection with their early sale get no tax exclusion: They pay full capital gains tax on every dollar of their profits.

The reduced exclusion for those who qualify is a fraction of the standard $250,000/$500,000 exclusion. For example, a single homeowner who is transferred by her employer after owning her home for 18 months--six months short of the required 24-month minimum--could qualify for a reduced exclusion of three-fourths (18 months/24 months) of the maximum $250,000 tax-free exclusion or $187,500.

The same taxpayer could qualify for similar relief if she had to sell the house after 18 months because of an extended hospitalization for a health problem. Ditto if she had to sell for a bona fide unforeseen circumstance forcing a premature sale. What precisely is an unforeseen circumstance? Congress threw the task of defining “unforeseen” to the IRS, which it directed to issue “guidance, including regulations and letter rulings” for taxpayers. Early last year the IRS held a public hearing seeking advice, but it has not yet made conclusions.

That, in turn, leaves some taxpayers scratching their heads--especially in the dozens of real estate markets around the country that have experienced double-digit home value appreciation during the last two years.

Back to the basic question: What is an unforeseen circumstance? A highly aggressive definition would include almost anything that a taxpayer didn’t anticipate--unpleasant neighbors, barking dogs next door, unexpectedly loud street noise. To be extreme, you could argue that just about everything is unforeseen.

You can be certain that the IRS’ view of unforeseen will be considerably more restrictive than that. At the public hearing last year, the agency took note of suggestions from tax professionals representing the American Institute of Certified Public Accountants and the National Assn. of Realtors.

Among their proposals for unforeseen events qualifying sellers for reduced exclusions were:

* A change in the health of a family member, necessitating an early sale of the home. You might, for example, have to relocate to help care for a family member in poor health.

* The death of a spouse, a co-owner or a family member.

* Divorce or legal separation requiring sale of the house.

* Unexpected financial hardship, such as the loss of employment by a resident of the house who helps pay the mortgage.

All these appear to fit the spirit of what Congress meant when it added the unforeseen circumstances safety net. Should you use one of them to claim a reduced exclusion? You know the answer here: Talk to your professional tax advisor. Explain the circumstances affecting your early sale and why they were indeed unforeseen.

Then hope for sympathy from the IRS.

Ken Harney’s e-mail address is ken harney@aol.com. Distributed by Washington Post Writers Group.