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Home seller's gain: New regs favorably interpret 1997 taxpayer relief act. (Federal Tax).

On Dec. 24, the IRS published final, temporary and proposed regulations regarding the exclusion of gain from the sale or exchange of a principal residence under IRC Sec. 121. These regulations generally apply to sales or exchanges after Dec. 23, 2002.

However, taxpayers may elect to apply these new regulations for sales or exchanges after May 6, 1997, if the statute of limitations for claiming credits or refunds has not expired.

This election is made by filing a return for the tax year of the sale or exchange of the taxpayer's principal residence that excludes the gain from gross income. If a return for such a year has been filed, this election is made by filing an amended return.

Audit Protection

The final regulations provide that the IRS will not challenge a taxpayer's position that a sale or exchange before Dec. 24, 2002--but after May 6, 1997--qualifies for the exclusion if the taxpayer has made a reasonable, good-faith effort to comply with Sec. 121's requirements. Compliance with the regulations proposed in 2000 generally will be considered a reasonable, good-faith effort.

The temporary (and proposed) regulations provide that the IRS will not challenge a taxpayer's position that a sale or exchange before Dec. 24, 2002-- but after May 6, 1997--qualifies for the reduced exclusion if the taxpayer has made a reasonable, good-faith effort to comply with Sec. 121(c)'s requirements and if the sale or exchange otherwise qualifies under Sec. 121.

Mixed-use Residences

A mixed-use residence is one that is used partially for residential and business purposes. Under the regulations proposed in 2000, only the gain allocable to the residential portion could be excluded under Sec. 121 if a mixed-use residence was sold or exchanged.

However, under the final regulations, no allocation of gain is required if both the residential and business portions of the property are within the same dwelling unit. But Sec. 121 will not apply to the gain to the extent of any post-May 6, 1997 depreciation adjustments.

Example 1: On July 1, 1999, Joe moves into a house that he owns and had rented to tenants since July 1, 1997. His depreciation deductions were $14,000 for the period that he rented this property. After using the property as his principal residence for two years, Joe sells it on Aug. 1, 2001, and realizes a $40,000 gain. (Joe has no other 2001 Sec. 1231 or capital gains or losses.) Only $26,000 ($40,000 gain less the $14,000 depreciation deductions) may be excluded under Sec. 121. Joe must recognize $14,000 as unrecaptured Sec. 1250 gain, taxable at a 25 percent maximum rate.

Example 2: Jane, a CPA, buys a house--which constitutes a single dwelling unit--in 2003. She uses part of the house as her business office. Jane claims $2,000 in depreciation deductions during the period that she owns the house. She sells the house in 2006, realizing a $13,000 gain. (Jane has no other 2006 Sec. 1231 or capital gains or losses.) She must recognize $2,000 as unrecaptured Sec. 1250 gain.

However, Jane may exclude the remaining $11,000 gain because she is not required to allocate any gain to the business use since both the property's residential and business portions are within the same dwelling unit.

Example 3: Bob buys a three-story townhouse and converts the basement, which has a separate entrance, into a separate apartment by installing a kitchen and bathroom and removing the interior stairway from the basement to the upper floors. After this conversion, the property constitutes two separate dwelling units.

Bob uses the upper floors as his principal residence and rents the basement to tenants from 2003 to 2007. He claims $2,000 in depreciation deductions for that period regarding the basement.

Bob then sells the townhouse in 2007, realizing an $18,000 gain. (He has no other 2007 Sec. 1231 or capital gains or losses.)

Because the basement and the upper floors are separate dwelling units, Bob must allocate this gain between the townhouse's residential and rental portions.

After allocating the basis and the amount realized between these portions, Bob determines that $12,000 of the gain is allocable to the residential portion and $6,000 is allocable to the rental portion. Therefore, he may exclude $12,000 of this gain. But Bob must recognize $6,000 of this gain as follows: $2,000 as unrecaptured Sec. 1250 gain and $4,000 as adjusted net capital gain.

Example 4: Assume the same facts as in Example 3, except that in 2007, Bob re-incorporates the basement into his principal residence by eliminating the kitchen and building a new stairway to the upper floors.

He uses all three floors as his principal residence for two years and sells the townhouse in 2010, realizing a $20,000 gain. Bob must recognize $2,000 of this gain as unrecaptured Sec. 1250 gain. Because he used all three floors as his principal residence for two of the five years preceding the property's sale, Bob may exclude the remaining $18,000 gain.

Look for further coverage in the May issue.

Stuart R. Josephs, CPA, has a San Diego-based Tax Assistance Practice (TAP) specializing in assisting practitioners in resolving their clients' tax questions and problems. Jose phs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at (619) 469-6999 or at sjosephs@bdo.com.
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Author:Josephs, Stuart R.
Publication:California CPA
Geographic Code:1USA
Date:Mar 1, 2003
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