Home (Tax) Free

By Lisa Takeuchi Cullen

With the stock market in a slump, chances are you're not fretting about owing taxes on stock gains come April 15. In fact, your only gain is probably in your house. But if you bought and sold a home for a profit over the past five years, here's some welcome tax-season news: recently issued guidelines from the Internal Revenue Service say you may have shelled out capital-gains taxes unnecessarily, and you should get the money back.

Here's why. The big tax-rule overhaul of 1997 let married homeowners filing jointly pocket up to $500,000 of their home-sale gains tax free, while single filers could keep $250,000. Until then, sellers could defer taxes only by plowing gains into a new house, then taking a once-in-a-lifetime exclusion of up to $125,000 at age 55 or older.

Though welcomed, the 1997 revision left a lot of taxpayers (and advisers) scratching their head. It stipulated that the house had to be a principal residence, but didn't spell out what that meant for people who split time between abodes. It seemed to exclude home offices from the break. And it specified that sellers had to have lived in a house for two of the five years before the sale--without cutting any breaks for people forced to sell before then.

The IRS says it doesn't know how many people have paid the tax needlessly. Capital gains are taxed at a maximum rate of 20%, which, while lower than the maximum rate for income, is still a big bite. Those who have sold since 1999 and paid taxes by mistake may be able to claim a refund by filing an amended return on Form 1040X. But hurry: there's a three-year deadline for tax refunds--which in most cases means a tax filing for a 1999 home sale should be amended by April 15. Here's what the new guidelines say:

--What is a principal residence? If you spend seven months a year in a Baltimore, Md., duplex and five in a Miami condo, it's the duplex. You can easily prove you used it as your main home for two (not necessarily consecutive) years of the five before you sold; just produce appropriate bills and receipts. (Year-round landscaping bills won't cut it, but supermarket receipts will.)

--Do I owe gains tax if I sold without meeting the two-year requirement? Yes--but you can take a partial exclusion based on how long you owned and used the home, if you sold it for certain reasons. These include a shift in place of employment of more than 50 miles; a health problem for which a doctor advised moving; and "unforeseen circumstances," ranging from divorce, job loss, multiple births from a pregnancy to a natural or terrorist disaster. "If you fall under one of these safe harbors," says Lewis Fernandez, deputy associate chief counsel of the irs division overseeing the regulations, "we will not challenge you."

--What about my home office? Good news: assuming you meet the other requirements, the new guidelines make clear that your whole gain is tax free, says Doug Stives, a CPA with the Curchin Group in Red Bank, N.J. (The exclusion used to be reserved for just the living space.) But there is a small catch--you will have to pay income tax on any home-office depreciation you have deducted since 1997.