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Salvage big tax break for an unexpected home sale

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in Small Business Tax,Small Business Tax Deduction Strategies

Due to extenuating circumstances, you may not qualify for the giant home-sale gain exclusion when you sell your principal residence. But if you can’t get the whole loaf of bread, at least grab a slice of it.

Strategy: Claim the partial home-sale gain exclusion whenever possible. In some cases, the tax law permits you to reduce the amount of the taxable gain on the sale, even if you don’t meet the full term the law requires.

The IRS just issued two new rulings that provide a window into the tax rules for partial exclusions.

Here’s the whole story: If you’ve owned and used your home as your principal residence for at least two of the previous five years, you can elect to exclude from federal income tax the first $250,000 of home-sale gain ($500,000 for joint filers). The exclusion isn’t available if you’ve claimed one within the past two years.

But if you sell your home without meeting the two-year requirement—or you elected the exclusion within the past two years—you may still be able to claim a partial exclusion. To qualify, the sale must have resulted from a change in employment, a health-related reason or unforeseen circumstances.

What are “unforeseen circumstances” for this purpose? The IRS established safe harbors under the prevailing regulations for death; divorce; loss of employment; a job change that reduces the ability to pay for the home; multiple births from the same pregnancy; damage from a natural or man-made disaster; or the taking of property.

If none of those safe harbors apply, the IRS will examine the facts and circumstances particular to the case.

Critical factors:

1. Whether the home has become less suitable as the principal residence.

2. If your ability to pay for the home has materially decreased.

3. If you reasonably could have anticipated the reason for the sale when you bought the home.

New ruling No. 1: A police officer, who was a narcotics investigator, arrested an alleged drug dealer. The police department learned that the drug dealer had discovered the officer’s address and was threatening his life. Because the policeman feared for his family’s safety, he sold his home and moved.

The IRS concluded that an unanticipated event had caused the house’s sale. Therefore, the officer was entitled to a partial home-sale gain exclusion. (IRS LR 200615011)

New ruling No. 2: After moving into their home, a married couple decided to adopt an orphan girl from a foreign country. But state law would not allow the adoption unless the girl had a separate and sizable bedroom.

To meet that requirement and other technical rules for the adoption process, the couple rented a house and sold the home they owned. The IRS judged this to be an unforeseen circumstance. Result: The couple can claim the partial home-sale exclusion. (IRS LR 200613009)

Tip: Although you shouldn’t rely on either of these rulings as precedent, they give you a good idea of the direction that the IRS is leaning.

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