'Unforeseen circumstances' can help you avoid taxes

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Homeowners typically can sell their primary residences free of capital gains taxes if they meet certain requirements.

The IRS even cuts taxpayers some additional slack in the event of death or divorce.

But Congress went a step further when it enacted Section 121 of the Internal Revenue Code.

This allows exclusion of at least some gain if the home is sold because of changes in health, employment or unforeseen circumstances and the sale would not otherwise qualify under Section 121.

If these exceptions apply, then homeowners get a reduced exclusion based on a ratio that compares how long the home was lived in and owned by the homeowner to two years (24 months).

For example, if the homeowner lived in and owned the home for 18 months before selling it, the exclusion would be 75% (or 18/24) of normal, which is $250,000 if single and $500,000 if married.

Consider this example:

Andres and Pamela marry and purchase a home in January 2011. Because of a change in circumstances, they sell their home in January 2012 and recognize a capital gain of $100,000.

If the change in circumstances qualifies under Section 121, Andres and Pamela’s normal capital gain exclusion of $500,000 is reduced by half to $250,000 (12 months lived in the home divided by 24 months, or 12/24).

The entire gain is still excluded from their income because it is less than Andres and Pamela’s now-reduced exclusion of $250,000.

Homeowners automatically qualify for the reduced exclusion if:

In all cases, the change of employment, health issue or unforeseen circumstances must actually be the main reason for selling the home.

If these specific circumstances are not met, the reduced exclusion may still be allowed if the taxpayer can make a good argument. The IRS has allowed the reduced exclusion in circumstances not specifically spelled out by the regulations.

Section 121 may be one of the most taxpayer-friendly in the entire Internal Revenue Code. If home prices ever start to go back up, homeowners just might get to take advantage of it.

Clint Costa is an attorney and CPA at the Chicago law firm of Shaheen, Novoselsky, Staat & Filipowski in Chicago.

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