For most people, the opportunity to exclude the gain on the sale of their home is the biggest tax exclusion of their lifetime. But this income tax exclusion can be lost if you give away your home to someone else! Careful planning includes advising you and your family about unexpected mistakes and problems involving taxation and the transfer of your home.

§121 of the Internal Revenue Code is the authority for the principal residence exclusion. This law excludes:

• $250,000 in gain on the sale of a principal residence for a single homeowner, or
• $500,000 of gain for home owned by a married couple.

To exclude this gain you must pass two tests:

• Ownership test: During the 5 year period ending on the date ofthe sale you owned the home for at least 2 years;
• Use Test: During that 5 year period, you lived in the home as your main home, and during the 2 year period ending on the date of the sale, you didn't exclude gain from sale of another home.

You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale of your house. The IRS regulations at 26 CFR Section 1.121-1(c) and IRS Publication 523 have more examples of how an elder can satisfy the ownership and use tests:

The Use Test is less strict for elders who need care that can’t be provided in their residence. Special Rules in §121(d)(7) give a safe harbor to people who become incapable of self-care. If they own the property used as the principal residence during the 5-year period for periods aggregating at least 1 year, they are treated as using such property as their principal residence during any time during such 5-year period in which the taxpayer owns the property and resides in a licensed facility, such as a nursing home.

If a residence is owned by a grantor trust (such as an Income Only Irrevocable Trust) for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.

There are Safe Harbors, providing partial exclusion of gain, such as change in place of employment, health, or unforeseen circumstances. Pub 523 has worksheets and explanations. The IRS has also published a discussion of the rules. I will review your special circumstances, and advise you on all the options for protecting your rights to the principal residence exclusion.

Beginning on January 1, 2010 there is no more estate tax. Transfers upon your death will be taxed using the concept of "carryover basis." For more details, see my article on Estate Taxes in 2010 and Beyond. An amendment to §121(d) has extended the principal residence exclusion to a home sold by:

• (A) the estate of a decedent
• (B) any individual who acquired such property from the decedent (within the meaning of section 1022), and
• (C) a trust which, immediately before the death of the decedent, was a qualified revocable trust (in other words a "living trust" as defined in section 645 (b)(1)) established by the decedent.

The exclusion will be "determined by taking into account the ownership and use by the decedent." This is applicable to estates of decedents dying after Dec. 31, 2009.

Q. What about Life Estates, for Parents who Have Transferred Remainder Ownership of the Homes to their Children? Unfortunately, the change in the tax laws will take away the step up in basis that is now provided to people who transferred ownership of their homes and retained life estates in the property. If we look at §1014(f), we see that Section 1014, the section allowing the step up in basis, "shall not apply with respect to decedents dying after December 31, 2009." So, where a life estate/remainder interest has been used to avoid probate and protect a home from Medicaid liens, the children will not be able to sell the home on a tax-free basis when the parent dies. >>> more information.

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