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Housing has been -- and remains -- the great American dream. If you own your own home, our tax laws give you two important tax benefits: you can deduct your real estate taxes as well as the interest you pay on your mortgage while you own your house, and then when it is sold, if you meet certain technical requirements, a sizable amount of your profit is tax-free.

In order to qualify for these tax benefits, however, the home in which you live must be your legal, principal residence. And although these deductions are also available for investment properties, this column will address only your home.

There is no statutory definition for principal residence in the Tax Code. If you ask an IRS agent -- or your tax attorney -- for a definition, she will advise you that "whether or not property is used by the taxpayer as his principal residence ... depends on all the facts and circumstances in each case, including the good faith of the taxpayer."

There have been very few court cases in which this concept has been defined, and in each opinion the courts give the same answer: We will investigate the facts of each case, and make our decision based on those specific facts, on a case-by-case basis.

If you have lived in the same home for many years, and consider it to be your principal home, it will clearly be your "principal residence." The key elements which the Courts and the IRS consider include your voter's registration, where you pay local or state income taxes, and the address on your driver's license. However, if you moved out of your house and have been renting it for some time, you will have to review the specific facts involving your particular situation, to make sure that you still qualify for the basic homeowner tax benefits.

In its regulations, the IRS states that "The mere fact that property is, or has been, rented is not determinative that such property is not used by the taxpayer as his principal residence."

The IRS gives the following illustration: "If the taxpayer purchases his new residence before he sells his old residence, the fact that he temporarily rents out the new residence during the period before he vacates the old residence may not, in light of all of the facts and circumstances of the case, prevent the new residence from being considered as property used by the taxpayer as his principal residence."

The tax courts -- and now the law -- make it very clear that a taxpayer is not required to actually occupy the old residence on the date of sale. The courts -- and the IRS -- will look at the particular facts and circumstances. More importantly, they will look to the good faith of the taxpayer.

If the homeowner has two houses and uses each as a residence for successive periods of time, (such as alternating between Florida in the winter and Washington during the rest of the year) subject to the decision of a recent case which will be discussed below, the property that the homeowner uses a majority of the time during the year will usually be considered the principal residence.

And it is to be noted that a cooperative housing apartment, a house trailer or a houseboat will also be considered a "principal residence," so long as it contains a kitchen, sleeping quarters and bathroom facilities.

Why is it important to establish that your home is your principal residence? Because when you sell your home, a married couple filing jointly can exclude up to $500,000 of profit (capital gain) so long as the house has been owned and used for an aggregate of at least two-of-the-five years before the house is sold. An unmarried individual (or a person filing a separate tax return) can exclude up to $250,000 of gain. Neither the IRS nor the courts have the authority to extend this time.

It should be noted, however, that on November 11, 2003, President Bush signed into law the Military Family Tax Relief Act of 2003 (referred to as MFTRA). This new law allows for the suspension of the five-year period during which these two-year use and occupancy requirements must be met. A person in the military (or in the foreign service) may elect to suspend these requirements for a maximum of 10 years. This will now be known as "qualified official extended duty," and is defined as any extended duty while serving at a duty station that is at least 50 miles from the taxpayer's principal residence, or while living in government quarters under government orders.

NOTE: This election is retroactive to sales after May 6, 1997. If you believe you qualify for this suspension, you have the right until November 10, 2004, to file a claim for a credit or a refund. Discuss this immediately with your tax advisors; you do not want to lose this important tax benefit.

The operative words for this exclusion are "owned and used." If you are married, so long as either spouse meets this requirement, the exclusion of gain applies. Marital status is determined on the date the house is sold. In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirement will include any time that the former spouse actually owned the property before the transfer to the other spouse.

The IRS issued regulations, effective December 24, 2002, and stated: "The residence that the taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayer's principal residence ... (but) this test is not dispositive. The final regulations include a nonexclusive list of factors that are relevant, such as:

  • Vacant land: Prior to 1997, a sale of vacant land that did not include a dwelling house did not qualify as a sale of the taxpayer's residence. In most cases, such a sale would trigger capital gain. Now, under the regulations, if the land is adjacent to the principal residence, and the residence has been owned and used by the taxpayer for two-out-of-the-five years, so long as the sale of the principal residence occurs within two years before or after the sale of the vacant lot, it will qualify for the exclusion. However, the sales are treated as only one sale; the taxpayer cannot exclude from gain more than the $250,000 - 500,000 exclusion.
  • Occupancy: Although the regulations do not require continuous occupancy, in order to qualify for the exclusion, the taxpayer must prove that he or she has lived in the property for a full 24 months (or 730 days). Short absences -- such as vacation or other seasonal absences -- are permitted; a one-year sabbatical is not."

    Last year, the Federal District Court in Arizona held that a couple who had lived in their Wisconsin home for a period of five years before it was sold could still not qualify for the exclusion of gain. Mr. and Mrs. Guinan lived in their Wisconsin home during the summer months, and spent the remainder of their time either in Georgia or Arizona. Although the Court agreed that the Guinan's had spent more days in Wisconsin than in their other homes, the Court strictly interpreted the IRS Regulations, and ruled that residing the most days during the five-year period in one of multiple residences is not the critical factor in determining whether the home was their principal residence. Instead, the Court found that since the Wisconsin home was not used as their principal residence on a year-by-year basis, it did not qualify.

  • Unmarried joint owners: The IRS clarified an issue which has been a great concern to a lot of property owners. For joint owners who are not married, so long as the owners qualify for the exclusion -- in other words, meet the use and occupancy requirements -- each owner can exclude up to $250,000 of gain attributable to their respective interests in the property.

    This last clause is significant. If two people own property as joint tenants or tenants in common on a 50-50 basis, then each can exclude up to $250,000 of their share of the gain. However, if one person owns 75 percent of the property, that owner can exclude 75 percent of the gain (not to exceed $250,000), and the other owner can exclude the remaining 25 percent -- again, not to exceed $250,000.

  • Ownership by trusts: Trusts have become a popular ownership tool in recent years. For a number of reasons -- including tax purposes, estate planning or merely to hide assets from public view -- property is being transferred into some kind of trust.

    The IRS clarified and simplified the rules: If the residence is held by a trust, the taxpayer is still considered as owning the property for purposes of complying with the two-year use and ownership requirements. For all practical purposes, the IRS will look to the facts and circumstances of the owner -- not the trust.

  • Death of one spouse: Husband and wife have owned and lived in their property for many years. The husband dies in January of this year. In order to qualify for the full $500,000 exclusion of gain, the surviving spouse must sell the property by the end of the year. Why? Because the $500,000 exclusion is only applicable where the parties file a joint return, and a surviving spouse can only file such a return for the year of the death. If the house is sold afterwards, the surviving spouse can only file a single return, and thus can only exclude $250,000 of gain.

    However, all is not lost. Remember the concept of the stepped-up basis. The wife's basis for tax purpose would be one-half of the initial cost of the property (plus any improvements) plus one-half of the fair market value of the property on the date her husband died. This should reduce the taxable consequences, but once again, discuss these issues with your tax advisors before you enter into any sales contract.

    Thus, the question becomes: How important is the concept of "principal residence" under the new tax laws? The answer is that the exclusion will not apply unless the property is in fact your principal residence. Once this is determined, and if you meet the use and occupancy requirements, you should be eligible for the capital gains exclusion.

    The burden of proof will be on you, the homeowner, to demonstrate that (1) this was your principal residence, and (2) you have, in fact, owned and used the house for two-out-of-five years before it was sold.

    How do you prove this?

  • Keep your driver's license which shows your former address; it should be noted that the Guinan's did not have Wisconsin licenses.
  • Don't throw out utility bills which could demonstrate the period of time in which your were living in the house;
  • Keep your voter registration card which shows the old address.

    All of these factors will play a role in determining the facts and circumstances of your particular case -- and the IRS will still apply the principal residence rules in determining "use and occupancy."

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