IRS' New Definition of 'Unforeseen Circumstances' Gives Break to Many

Most home buyers expect to stay in their homes for a long time. But sometimes, unexpected circumstances intrude. You lose your job. Your spouse runs off with the dog walker. Your new neighbors own 11 cars, and 10 of them are up on blocks.

Well, cheer up. If you have to sell your home, you'll probably avoid capital gains taxes on the profit, even if you've lived in it for less than two years.

Since 1997, homeowners have been able to exclude up to $250,000 — $500,000 if they're married — in home sale profit from capital gains taxes, as long as they've lived in the house for two of the past five years. The 1997 law also allowed a smaller tax break if "unforeseen circumstances" forced taxpayers to move before they met the two-year requirement.

Now, the IRS has offered guidance on what qualifies as an unforeseen circumstance. While the IRS probably won't give you a tax break for slovenly neighbors, its definition of an "unforeseen circumstance" covers just about everything else, tax analysts say.

"It's almost hard to imagine who isn't covered," says Mark Luscombe, research analyst for tax publisher CCH.

Some examples of events that qualify for a tax break:

• You're transferred or change jobs. Your new job must be at least 50 miles farther from your home than your former job was. This is the same standard the IRS uses to determine whether you can deduct moving expenses when you change jobs.
• You're selling the home because of divorce or legal separation.
• You can't afford the mortgage. If you're forced to sell because you lost your job or your salary shrunk, you're eligible for the tax break. Even a big increase in your condo fee could qualify as an unforeseen circumstance, says Alan Weiner, an accountant with Holtz Rubenstein in Melville, N.Y.
• You or a member of your family must move for health reasons. For example, if your doctor recommends relocating to Arizona to relieve your chronic asthma, you qualify for the tax break.

The IRS looks askance at general "quality of life" migrations. Moving from North Dakota to Florida may give you a healthier glow, but it probably won't pass muster with the IRS.

• Your home is damaged by a natural disaster, such as an earthquake, or a man-made calamity, such as a terrorist attack.
• You're shopping for a double stroller. Your house seemed plenty big when you bought it a year ago, but that was before the twins arrived. Good news: The IRS says "multiple births" qualify for a tax break on the sale of your home.

"That's a fairly liberal interpretation of an unforeseen circumstance," says Bob Trinz, editor of RIA's Federal Taxes Weekly Alert.

The amount of the reduced exclusion from capital gains taxes will be based on how long you've lived in your home. For example, suppose you buy a house, and a year later you're transferred to a job in another state. Because you've lived in the house for half the time required for a full exclusion, you could sell your home for a $125,000 profit — or $250,000 if you're married — without paying capital gains taxes. Unless you're moving out of Malibu, it's unlikely your home has appreciated more than $125,000 in a year.

The rules are retroactive. If you paid capital gains taxes on a home sale that is covered under the new rules, you can file an amended return to get a refund, Weiner says. File a Form 1040X for the year you reported the gain.

The rules also provide an important break for homeowners who claim a home-office deduction, Weiner says. In the past, the IRS required home sellers who used part of their homes for business purposes to report the sale as two separate transactions. Gains on the business part of the home weren't excluded from capital gains taxes.

Now, the IRS says you can exclude the entire sale, minus depreciation you've taken on the home office, from capital gains taxes.

The rule only applies if your home and business are in the same building, Weiner says. A detached garage that's been converted into an office doesn't qualify.

Keep good records

Even if your own circumstances don't fit neatly into the IRS definitions, you may still qualify for a tax break. The rules give the IRS discretion to consider other types of circumstances that may lead to a home sale.

You don't have to report a home sale gain to the IRS if you believe the profit is excluded from capital gains taxes. But if you've lived in the home for less than two years, you should keep good records in case you're audited. Useful documents include notice of a job transfer, a letter from your doctor or birth certificates for the quadruplets.

And if you're convinced your neighbors' hubcap sculpture garden qualifies as an "unforeseen circumstance" you may want to take some pictures of their backyard. Just be prepared to pay back taxes and penalties if the IRS disagrees.

Source: USA Today