Surprisingly, IRS relaxes home-sale rules

WASHINGTON -- March 11, 2003 -- Homes, long a source of lucrative deductions, could prove to be even more valuable tax shelters this year.

Among the reasons: the yearlong wave of mortgage refinancing, which can trigger write-offs for "points," or prepaid interest charges, and the Internal Revenue Service's decision to issue a surprisingly generous clarification of the tax rules governing certain home sales. The IRS relaxed the residency requirements for sheltering some of the profits from a home resale and also made it easier for home-based workers to shelter more of their home-sale gains.

Home sales. As in the past, people who sold their home last year can exclude up to $250,000 and married couples can exclude up to $500,000 in home-sale profits from taxable income on their 2002 returns, as long as the homeowner has lived in the residence for two of the last five years. Profits in excess of the excluded amounts are taxable at capital-gains rates.

The tax code also includes a few exceptions that allow home sellers who do not meet the minimum two-year residency requirement to qualify for a partial exclusion. And recently, the IRS clarified the rules to make it easier to claim a partial exclusion.

Under the old rules, taxpayers could get a partial exclusion when a move was required by a change of employment, health reasons, or "unforeseen circumstances." But the IRS did not clearly define what it considered "unforeseen." Last fall, the agency ruled that unforeseen circumstances could include:

* Divorce, legal separation, or death of a spouse.

* Becoming eligible for unemployment compensation.

* A change in employment that makes it impossible to pay the mortgage or basic living expenses.

* Multiple births resulting from the same pregnancy.

* Damage to the home from a natural disaster, an act of war, or terrorism.

* Condemnation, seizure, or involuntary conversion of the property, such as through foreclosure.

The size of the deduction depends on how long the seller lived in the house during the five years before the sale. A taxpayer who lived in a house for a year -- or 50 percent of the two-year requirement -- would be entitled to a 50 percent exclusion. That would allow home-sale profit of $125,000 per person, or $250,000 per couple, to be sheltered from tax.

Home offices. The IRS reversed a rule that had deterred taxpayers from claiming a deduction for their home offices.

The IRS previously said that a taxpayer who wrote off a portion of a home's value as a home office would lose the residential exclusion on that portion of the gain from a subsequent sale. In other words, if 10 percent of the home was used as an office and the home was subsequently sold at a $100,000 profit, 10 percent of the profit, or $10,000, would be taxable.

Now the IRS says taxpayers can exclude as much of their home-sale profit as the law allows, as long as the office is in the same dwelling -- in other words, if the office was a room in the house, not in a separate guest house or garage.

Refinancing. Taxpayers should review the rules on "points," or prepaid interest.

On a loan used to buy a principal residence, all the points are deductible in the year they are paid, said Bob Walters, chief economist for Quicken Loans. On a loan used to buy a second home or to refinance a mortgage, the points must be amortized over the life of the loan, he said. So a person who paid $3,000 in points on a 30-year mortgage would write off $100 of that expense -- $3,000 divided by 30 -- each year.

Serial refinancers -- those who refinanced a refinanced loan -- should note that any undeducted points from a previous refinancing become fully deductible when the new refinancing goes through.

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