Tests for One-Time Exemption

Perhaps the most important tax benefit available to the homeowner is the so-called “senior citizen tax exemption.”

However, the name is a misnomer. We now recognize that at age 55, one is really not a “senior citizen.”

The once-in-a-lifetime exemption (Section 121 of the Internal Revenue Code) permits the taxpayer to exclude up to $125,000 on the profit of the principal residence under certain conditions.

First, the taxpayer must be at least 55 years of age before the date of sale. Turning 55 later in the year the property is sold does not meet the legal requirement.

Second, the exclusion applies only to the sale of the principal residence. This includes condominiums and cooperative apartments, but does not include a second home.

Third, the taxpayer must have owned and used the property as his or her principal residence for a total of at least three years during the five-year period ending on the date of the sale.

However, in 1988, Congress modified this three-year requirement for taxpayers who are physically or mentally incapable of self-care and who reside in any facility (including a nursing home) licensed by a state or political subdivision to care for an individual in the taxpayer’s condition. Under these circumstances, the taxpayer only has to live in the property for at least one year during the previous five-year period.

If you meet these tests, you are entitled to deduct up to $125,000 of your profit from the sale of your home. If you are married--but file separate tax returns--the maximum exclusion is $62,500 for each return.

A historic review of this legislation reveals an interesting aspect of the American housing economy. The law was first enacted in 1964. At that time, the exclusion was $20,000. In 1976, it was amended to $35,000, and then changed to $100,000. Finally, in 1981, Congress raised the limitation to $125,000, where it has stayed ever since.

It should also be noted that if two unmarried individuals own property, and meet all of the legal requirements of Section 121 when the property is sold, both are entitled to take up to $125,000 as an exclusion from their taxes. For example, if two sisters live in a property for many years, when it is sold, even if they have made a profit of $250,000 on the sale of the house, if both own the property equally, both can take the $125,000 exclusion.

Although the rules sound relatively simple, there are some significant complications.

For example, a man has already taken the once-in-a-lifetime exemption. If he marries a woman who otherwise would be entitled to the same exemption for her property, she loses that right. Among the IRS agents, the husband in this example is known as a “tainted spouse.” The Internal Revenue Code seems to encourage couples not to marry until they have taken their once-in-a-lifetime exclusion.

Example: You and your prospective spouse are both over 55. Each of you own homes that originally cost $50,000, and are now each worth $200,000. Together, you would have a gain of $300,000. If you married before you sold your respective houses, you would be limited to an exemption of $125,000.

If, on the other hand, you both sell your houses before you marry, you can each exclude the $125,000, for a total of $250,000 worth of exemption.

Furthermore, in our example, you each sold your house for $200,000. You take the $125,000 exclusion. This means that each of you is eligible to rollover into a property costing at least $75,000 each. By pooling your resources, as long as your new house costs at least $150,000, in our example you will be able to combine the once-in-a-lifetime with the rollover, and pay no taxes.

As was discovered earlier in this series, the rollover is mandatory. However, the Section 121 once-in-a-lifetime is optional; the taxpayer has the right to elect to take--or not to take--the once-in-a-lifetime when he or she deems it desirable.

Indeed, there are times when you may want to revoke an election previously made, if your circumstances have changed. The law permits the election to be revoked at any time before the latest of the following dates: Three years from the due date of the federal income tax return for the year of sale, three years from the date the return was filed, or two years from the date the tax was paid.

If, on the other hand, the taxpayer is married, the revocation may be made only if the spouse joins in the revocation.

Tax considerations are perhaps the most important aspect to be reviewed when deciding whether and when to sell your house.