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01/12/09: Tax Benefits When Selling Your Home

Housing Counsel

By Benny L. Kass

(Third in a Series)

“The hardest thing in the world to understand is the income tax.”

Albert Einstein

Selling your house used to be easy. You list it with a real estate agent, and within days were deluged with offers – some even higher than your offering price.

But those good old days are gone. Today, a house can sit on the market for weeks – if not months – before you get an offer. And your potential buyer must go through many hurdles, and have an excellent credit rating, in order to get a mortgage loan commitment.

During this long wait, you begin to panic. You know that regardless of the ultimate sales price, your house has appreciated greatly since you first bought it, and you do not want to lose the tax benefits available to homeowners. What options do you have?

First, let’s briefly explain what is perhaps the greatest tax break currently available. If you have owned and use (lived in) your principal residence for two out of the five years before it is sold, you can exclude up to $500,000 of any profit if you are married and file a joint income tax return. If you are single, or file a separate tax return, the exclusion is limited to $250,000.

This is known as the “use and ownership” tests.

The law appears straight-forward. But each of us have different sets of facts. Let’s explore some of these situations:

death of a spouse: you and your spouse have owned and lived in the house for years, but last year your spouse died. Current law allows the surviving spouse to claim the full $500,000 exclusion if the sale is made not later than two years after the date of death, so long as both the use and ownership tests had been met at the time of death. However, in order to qualify for the full exclusion, the surviving spouse must not have remarried prior to the sale of the house.

tax liens: if you are delinquent with your income tax payments, the Internal Revenue Service can (and will) slap a tax lien against you and your home. According to the IRS, they issue more than 600,000 federal tax lien notices every year, and currently, there are more than 1 million such liens outstanding – many of which involve real estate.

Homeowners have a number of options. If you are planning to refinance – or if your lender is prepared to restructure your loan so as to make the monthly mortgage payments more attractive – you can ask the IRS to subordinate their lien. This means that while the lien will remain on the land records, it will be in second place behind your current lender. When a lender makes you a mortgage loan, it wants to be sure that it will be in first trust position. Should it have to foreclose, it will not be burdened with any lienholder ahead of it.

If you are selling your house for less than you currently own your mortgage lender – called a “short sale” – you can also request the IRS to completely discharge its claim. According to the Service, the process to request a discharge or a subordination of a tax lien will take approximately 30 days after receiving the formal request.

“We don’t want the IRS to be a barrier to people saving or selling their homes. We want to raise awareness of these lien options and to speed our decision-making process so people can refinance their mortgages or sell their homes”, said Doug Shulman, the IRS Commissioner.

Married persons: although I believe that married people should both have an ownership in their home, there are many homes owned only by one spouse. This does not affect their ability to claim the full up-to-$500,000 exclusion. So long as either spouse meets the ownership test, and both meet the use test, they can claim the full exclusion., However, if one spouse has already claimed the exclusion on another property within the past two years, the exclusion is limited to only $250,000.

This is a common situation where parties remarry and then want to sell their respective houses and buy another one together. Careful planning is required to maximize the exclusions and such couples should consult with their financial and tax advisors before they sign any real estate contracts.

Divorce: if you are divorced at the time the house is sold, so long as both parties meet the use and occupancy tests, each have the right to claim up to $250,000 exclusion of gain. But what if one spouse moves out of the house pursuant to a divorce or separation agreement? Several years later, the house is sold. According to the IRS, “if your home was transferred to you by your spouse (or former spouse if the transfer was incident to divorce), you are considered to have owned it during any period of time when your spouse owned it.” Additionally, in order to meet the use test, “you are considered to have used property as your main home during any period when” (1) you owned it and (2) your spouse or former spouse is allowed to live in it under a divorce or separation instrument and uses it as his or her main home.

So if you can meet both the use and occupancy tests, it makes no difference when the home was sold; you may be able to claim the up to $250,000 exclusion. Again, discuss your situation with your tax advisors. And if you are currently in the process of getting a divorce, make sure that you address the tax consequences of selling the family home in your legal separation agreement.

reduced minimum exclusion : if you have to sell your house and cannot meet the use and ownership tests, you may still be able to claim a partial (reduced) exclusion of any gain you have made. If the sale is a result of (a) a change in where you work, (b) health considerations, or (c) unforeseen circumstances, there is a formula to determine exactly how much of your gain can be sheltered. For more information – and to assist you in computing your exclusion – the IRS has issued Publication 523, entitled “Selling Your Home”, and it is available on-line from

These are difficult times, but you do not want to lose this valuable exclusion. Careful planning will keep money in your pocket, so it pays to discuss your situations with a financial and tax advisor before you sign any documents.