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When Your Home is Not a Principal Residence

“Houston, we have a problem.” Who could ever forget those famous words as one catastrophe after another unfolded for the astronauts in the movie, Apollo 13? After considering a recent client related situation, it hit me – America, we have a problem!

OK, I know that’s the number one topic these days – the problems facing America. Bear with me for just a moment; here’s one that I bet you have not considered. It is like the astronauts in Apollo 13. If life were not complicated enough in the hostile environment of space, unpredictable things happen and the consequences are unimaginable. Let me give you an example.

Like so many people today, suppose you receive a “pink slip” on Friday. No more job and with it the end to life as you and your family have known it. Ah, you are one of the lucky ones; an immediate job offer arrives just two days later. It’s a no-brainer. The family will relocate and move the 400 miles. Everything is going to be OK!

Fast forward three years; you are still living in a small apartment. Life is not bad, but once you are finally able to sell the house you left behind, everything will be great. You bought the house 15 years ago at a steal and an upper-end community just sort of grew up around you. Once this housing slump is over, the house will sell, you will pay off the mortgage, you and your family will move into the house on the hill and live happily ever after! Well maybe…

Here is the problem and so many people are not even aware that it exists. The prevailing belief is that the sale of your principal residence is nontaxable, but even if were, taxes can be avoided by using the money to invest in another home. America, we have a problem! While it is true that the sale of your principal residence is nontaxable – up to a $500,000 profit for a married couple, there is a trap.

In order for the home to qualify as your principal residence, it must have been owned and used as the principal residence at least 2 out of the last 5 years.

Clearly, if you moved out of your home and it has been on the market for more than 3 years, for tax purposes it is no longer considered your principal residence. If your previous home no longer meets the IRS definition of your principal residence, then the sale becomes a fully taxable transaction.

Here is an example. You purchased the home 15 years ago for $85,000. At some point you expect to sell the property for $150,000 (After closing costs). That $65,000 (Profit) could net a tax bill of $15,000 directly, and could actually subject you to a higher tax rate on your other income earned during the year. If the Bush tax cuts expire or if the new Health Care provisions apply to you, your income tax liability could climb even higher.

If your home has been on the market for a while, you might have a problem and the consequences could be quite severe.

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