As the holiday season approaches, the IRS and its Security Summit partners issued a timely warning to taxpayers, with a special emphasis on employers and payroll professionals, about the increased risk of scams and identity theft. This alert comes as part of the ninth annual National Tax Security Awareness Week, highlighting the need for vigilance in protecting sensitive personal and financial information. ( IR 2024-300 , 12/2/2024)
If you own a successful small business with no employees, you might be ready to set up a retirement plan. Or you might want to upgrade from a more-basic SIMPLE IRA or Simplified Employee Pension (SEP) plan. Here are two options — solo 401(k)s and defined benefit pension plans — to consider if you have healthy self-employment income and want to contribute substantial amounts to your retirement nest egg.
Important: This article is geared toward self-employed individuals. That includes sole proprietors, partners, owners of single-member limited liability companies (LLCs) that are treated as sole proprietorships for tax purposes and members of multi-member LLCs that are treated as partnerships for tax purposes.
Solo 401(k) Plans
With a solo 401(k) plan, you can potentially make large annual deductible contributions to your retirement account. However, that advantage comes with some administrative complexity.
Click here to learn the maximum contribution amount allowed for this year, as well as the “catch-up” contribution amount for those over age 50.
On top of your elective deferral contribution, an additional contribution of up to 20% of your net SE income is permitted for solo 401(k)s. This additional pay-in is called an “employer contribution,” though there’s technically no employer when you’re self-employed. For purposes of calculating the employer contribution, your net SE income isn’t reduced by your elective deferral contribution.
For the 2025 tax year, the combined elective deferral and employer contributions can’t exceed:
$70,000 ($77,500 if you’ll be 50 or older as of December 31, 2025), or
100% of your net SE income.
Net SE income equals the net profit shown on Form 1040 Schedule C, E or F for the business minus the deduction for 50% of self-employment tax attributable to the business. For further information, see “How Much Can You Contribute to a Solo 401(k)?” at right.
Besides the ability to make large annual deductible contributions, another key advantage of solo 401(k) plans is that contributions are completely discretionary. When cash is tight, you can contribute a small amount or nothing. In years when you’re flush with cash, you can contribute the maximum allowable amount.
In addition, you can borrow from your solo 401(k) account, assuming the plan document permits it (which you should insist on). The maximum loan amount is 50% of the account balance or $50,000, whichever is less. Some other retirement plan options, including SEPs, don’t allow loans.
The biggest downside to solo 401(k)s is their administrative complexity. Significant upfront paperwork and some ongoing administrative efforts are required, including adopting a written plan document and arranging for how and when elective deferral contributions will be collected and paid into the owner’s account. Also, once your solo 401(k) account balance exceeds $250,000, you must file Form 5500-EZ with the IRS each year. Fortunately, your tax and financial advisors can help you set up and operate the plan.
If your business has one or more employees, you obviously can’t have a solo 401(k). Instead, you’ll have a multi-participant 401(k) with all the resulting complications. The tax rules may require you to make contributions for those employees. However, there’s an important loophole: You can exclude employees who are under 21 and employees who haven’t worked at least 1,000 hours during any 12-month period from 401(k) plan coverage.
To take advantage of this exclusion rule, consider the feasibility of employing only younger and/or part-time workers. That way, you’ll effectively operate a solo 401(k).
Bottom line: For a one-person business, a solo 401(k) can be a smart tax-favored retirement plan choice if:
You want to make large annual deductible contributions and have the cash to do so,
You have substantial net SE income, and
You’re 50 or older and can, therefore, take advantage of the extra catch-up elective deferral contribution.
Before you jump on the solo 401(k) bandwagon, however, weigh the pros and cons of a defined benefit pension plan — especially if you’re 50 or older.
Defined Benefit Pension Plans
A defined benefit pension plan is designed to deliver a target level of annual payouts from your account after you reach a stipulated retirement age. You make annual deductible contributions, which must be calculated by an actuary, to fund target payouts.
Target payouts can be based on a fixed percentage of your average net SE income over a stipulated time period, a flat monthly dollar amount or a formula based on years of service. For the 2025 tax year, allowable contributions must be based on an annual target payout that can’t exceed $280,000 (up from $275,000 in 2024). A defined benefit pension plan can potentially allow large annual deductible contributions to fund generous retirement age payouts — resulting in large annual tax savings, especially if you’re 50 or over.
Making large annual tax-saving contributions might sound like a great idea, but not everyone has tons of cash available to cover big contributions. Plus, once your plan is set up, actuarially determined annual contributions are mandatory. In contrast, contributions to other types of plans are discretionary.
It’s also important to point out that defined benefit pension plans must generally cover your employees, too. However, the plan can include vesting and exclusion provisions to help prevent briefly employed workers from leaving with employer contributions.
Additionally, defined benefit plans are complicated. They generally require a customized plan document, along with annual actuarial calculations to determine how much to contribute each year. Your financial and tax advisors can help you crunch the numbers or locate a specialist who can help operate your pension at an affordable cost.
Bottom line: It’s important to clearly understand what you’re getting into before opting for a defined benefit pension plan.
How Much Can You Contribute to a Solo 401(k)?
When it comes to solo 401(k)s, elective deferral and employer contributions can really add up. To illustrate, suppose you’re 45 and operate a single-member limited liability company that’s treated as a sole proprietorship for tax purposes. In 2024, you have net self-employment (SE) income of $100,000 (after subtracting 50% of your SE tax bill).
In this case, the maximum deductible contribution to a solo 401(k) plan set up for your benefit would be $43,000. That amount is composed of 1) a $23,000 elective deferral contribution, and 2) a $20,000 employer contribution (20% of $100,000). This amount is significantly more than you could contribute to a Simplified Employee Pension (SEP). With a SEP, your maximum contribution would be $20,000 (20% of $100,000). The $23,000 difference is attributable to the solo 401(k)’s relatively generous elective deferral contribution.If, under the same business ownership scenario, you’re 50 or older, the maximum contribution to your solo 401(k) account would be $50,500. That amount is composed of 1) a $23,000 elective deferral contribution, including the $7,500 extra “catch-up” contribution, and 2) a $20,000 employer contribution (20% of $100,000).
What’s Best for You?
Solo 401(k)s and defined benefit pension plans are anything but simple. However, they can allow self-employed individuals to make substantial and deductible annual contributions to a retirement nest egg. Contact your tax and financial advisors before signing up for either option to determine what’s best for your situation.
Have you ever wondered how social security benefits fit into your taxes? How much they are taxed, or whether they are taxed at all, depends on your other income. In the worst-case scenario, 85% of your benefits would be taxed. (This doesn’t mean you pay 85% of your benefits back to the government in taxes—merely that you would include 85% of them in your income subject to your regular tax rates.)
To determine how much of your benefits are taxed, you must first determine your other income, including certain items otherwise excluded for tax purposes (for example, tax-exempt interest). Add to that the income of your spouse, if you file jointly. To this add half of the Social Security benefits you and your spouse received during the year. The figure you come up with is your total income plus half of your benefits. Now apply the following rules:
For married taxpayers, filing jointly:
1. If your income plus half your benefits is not above $32,000, none of your benefits are taxed.
2. If your income plus half your benefits exceeds $32,000 but is not more than $44,000, you will be taxed on (1) one half of the excess over $32,000, or (2) one half of the benefits, whichever is lower.
Example (1): S and D have $20,000 in taxable dividends, $2,400 of tax-exempt interest, and combined Social Security benefits of $21,000. So, their income plus half their benefits is $32,900 ($20,000 plus $2,400 plus 1/2 of $21,000). They must include $450 of the benefits in gross income (1/2 ($32,900 − $32,000)). (If their combined Social Security benefits were $5,000, and their income plus half their benefits were $40,000, they would include $2,500 of the benefits in income: 1/2 ($40,000 − $32,000) equals $4,000, but 1/2 the $5,000 of benefits ($2,500) is lower, and the lower figure is used.)
For single taxpayers:
1. If your income plus half your benefits is not above $25,000, none of your benefits are taxed.
2. If your income plus half your benefits exceeds $25,000 but is not more than $34,000, you will be taxed on (1) one half of the excess over $25,000, or (2) one half of the benefits, whichever is lower.
Example (1A): S has $20,000 in taxable dividends, $2,400 of tax-exempt interest, and Social Security benefits of $9,000. So, S’s income plus half S’s benefits is $26,900 ($20,000 plus $2,400 plus 1/2 of $9,000). S must include $950 of the benefits in gross income (1/2 ($26,900 − $25,000)). (If S’s Social Security benefits were $3,000, and S’s income plus half S’s benefits were $30,000, S would include $1,500 of the benefits in income: 1/2 ($30,000 − $25,000) equals $2,500, but 1/2 the $3,000 of benefits ($1,500) is lower, and the lower figure is used.)]
For either married or single taxpayers:
In many cases, If your income, plus half your benefits exceeds the limits listed above ($44,000 for married, or $34,000 for single taxpayers], the computation grows far more complex. Generally, however, unless your income plus half your benefits is fairly close to $44,000 [$34,000 for single taxpayers], if you fall into this category, 85% of your Social Security benefits will be taxed.
Caution: If you aren’t paying tax on your Social Security benefits now because your income is below the above floor, or are paying tax on only 50% of those benefits, an unplanned increase in your income can have a triple tax cost. You’ll have to pay tax (of course) on the additional income, you’ll also have to pay tax on (or on more of) your Social Security benefits (since the higher your income the more of your Social Security benefits that are taxed), and you may get pushed into a higher marginal tax bracket. This situation might arise, for example, when you receive a large distribution from a retirement plan (such as an IRA) during the year or have large capital gains. Careful planning might be able to avoid this stiff tax result. For example, it may be possible to spread the additional income over more than one year, or liquidate assets other than an IRA account, such as stock showing only a small gain or stock whose gain can be offset by a capital loss on other shares. If you expect a large increase in your income, or you should need a large amount of cash for a specific purpose, please contact us before liquidating any assets. We can determine just what your additional tax cost will be and potentially reduce this cost with some planning.
If you know your social security benefits will be taxed, you can voluntarily arrange to have the tax withheld from the payments by filing a Form W-4V. Otherwise, you may have to make estimated tax payments.
If you’d like us to run some specific numbers for you, or if you would like to discuss this matter further, please call.
UPDATE: The IRS has further extended the deadline to October 16, 2023: Disaster-area taxpayers in most of California and parts of Alabama and Georgia now have until October 16, 2023, to file various federal individual and business tax returns and make tax payments, the Internal Revenue Service announced on Friday. Previously, the deadline had been postponed to May 15th for these areas. See IR-2023-33, Feb. 24, 2023 for further details.
The IRS has provided disaster tax relief to victims of California storms that began on January 8, 2023. According to the IRS, storm victims who live or have a business in the disaster area now have until October 16, 2023, to file various federal individual and business tax returns and to make tax payments.
Disaster area. The disaster area includes the following counties: Alameda, Colusa, Contra Costa, El Dorado, Fresno, Glenn, Humboldt, Kings, Lake, Los Angeles, Madera, Marin, Mariposa, Mendocino, Merced, Mono, Monterey, Napa, Orange, Placer, Riverside, Sacramento, San Benito, San Bernardino, San Diego, San Francisco, San Joaquin, San Luis Obispo, San Mateo, Santa Barbara, Santa Clara, Santa Cruz, Solano, Sonoma, Stanislaus, Sutter, Tehama, Tulare, Ventura, Yolo, and Yuba.
Postponed deadlines. The IRS has postponed various tax filing and payment deadlines that occurred beginning on January 8, 2023. As a result, individuals and households who live or have a business in the disaster area will have until October 16, 2023, to file returns and pay taxes that were originally due during this period.
This tax relief includes business returns due on March 15 and business and individual returns due on April 18, 2023. In addition, farmers who forgo making an estimated tax payment in January and normally file their returns by March 1, now have until October 16, 2023, to file their 2022 return and pay any tax due.
The October 16, 2023, deadline also applies to:
The quarterly estimated tax payments normally due on January 17, April 18, June 15 and Sept. 15 .
The quarterly payroll and excise tax returns normally due on January 31, April 30 and July 31.
In addition, penalties on payroll and excise tax deposits due on or after January 8, 2023, and before January 23, 2023, will be abated if the tax deposits are made by January 23, 2023.
Relief is automatic. The IRS will automatically apply this tax relief to any taxpayer with an address in the disaster area (“affected taxpayers”). However, affected taxpayers that receive a penalty notice from the IRS for a return that has a due date falling within the postponement period (January 8, 2023, to October 16, 2023) should call the phone number on the notice to have the penalty abated.
In addition, taxpayers who live or have a business outside the disaster area but whose tax records are in the disaster area and workers assisting in disaster relief activities should call the IRS at 866-562-5227 to ask for this tax relief.
Disaster losses. Victims in the disaster area who suffered uninsured or unreimbursed disaster-related losses can choose to claim them on either the current year (2023) or prior year 2022 return. Taxpayers claiming disaster losses should write the FEMA declaration number—3691-EM—on any return claiming such a loss.
As of this posting, California has not conformed to this extended relief however, we expect they will shortly.
Please keep in mind that this relief doesn’t apply to information returns such as Forms W-2, 1094, 1095, 1097, 1098 or 1099 series; to Forms 1042-S, 3921, 3922 or 8027. These forms still have their normal due dates.
We recommend that you still submit all 2022 documents to our firm for completion of your return as soon as possible and use this relief as an opportunity to pay any tax as late as October 16th
Income that you generate conducting your business as a sole proprietorship (or through a wholly-owned limited liability company (LLC)) is subject to both income tax and self-employment tax. The self-employment tax is imposed on 92.35% of self-employment income at a 12.4% rate for social security up to the social security maximum ($142,800 for 2021; $147,000 for 2022) and at a 2.9% rate for Medicare. An additional 0.9% Medicare tax is imposed on income exceeding $250,000 for married couples ($125,000 for married persons filing separately) and $200,000 in all other cases. No maximum tax limit applies to the Medicare tax. Similarly, if you conduct your business as a partnership in which you are a general partner, in addition to income tax you would be subject to the self-employment tax on your distributive share of the partnership’s income. On the other hand, if you conduct your business as an S corporation you will be subject to income tax, but not self-employment tax, on your share of the S corporation’s income.
An S corporation is not subject to tax at the corporate level. Instead, the corporation’s items of income, gain, loss, and deduction are passed through to the shareholders. However, the income passed through to the shareholder is not treated as self-employment income. Thus, by using an S corporation, you can avoid self-employment income tax.
There is a problem, however, in that IRS requires that the S corporation pay you reasonable compensation for your services to the S corporation. The compensation is treated as wages subject to employment tax (split evenly between the corporation and the employee), which is equivalent to the self-employment tax. If the S corporation does not pay you reasonable compensation for your services, IRS may treat a portion of the S corporation’s distributions to you as wages and impose social security taxes on the deemed wages. There is no simple formula regarding what is reasonable compensation. Presumably, reasonable compensation would be the amount that unrelated employers would pay for comparable services under like circumstances. There are many factors that would be taken into account in making this determination.
Give us a call today to discuss the practical aspects of conducting your business through an S corporation and how much the S corporation would have to pay you as compensation.
Speaking broadly, you may be able to benefit by carrying what is called a “net operating loss” (NOL) into a different year-a year in which you have taxable income-and taking a deduction (the “NOL deduction”) for the loss against that year’s income.
The NOL deduction equals the total of your NOL carryovers and NOL carrybacks to the particular tax year. But, for tax years after 2020, the deduction will be subject to an 80%-of-taxable income limitation.
Your NOLs for tax years 2018, 2019 and 2020 are carried back for five years. But, NOLs for 2021 and later tax years generally can’t be carried back (although farm losses can be carried back two years). And, NOLs for tax years after 2017 are generally carried forward indefinitely.
You must carry the NOL first to the earliest year allowed, and, then, successively, to the next earliest year, etc. until the loss is used up. But, if it would benefit you more to just carry a NOL forward, you can waive carryback of that loss.
To determine the amount of your NOL for a particular tax year, you don’t just use the negative taxable income reported on your tax return for that year. Instead, several modifications must be made to compute the amount of your NOL. These include the following:
(1) You cannot use your personal or dependency exemptions-for the years in which these are available (i.e., after 2025 and before 2018).
(2) You cannot use any NOL from a different year.
(3) “Nonbusiness” capital losses (those arising outside of your trade or business, or your employment) can only be used against “nonbusiness” capital gains. Excess capital losses cannot increase your NOL.
(4) “Nonbusiness” deductions (e.g., charitable donations, deductible medical expenses, mortgage interest, alimony, etc.) can only be used against “nonbusiness” income (interest, dividends, etc.). That is, they cannot directly increase your NOL. However, if you have nonbusiness capital gains in excess of nonbusiness capital losses (see (3), above), you can use your “excess” nonbusiness deductions against these gains. (Note that casualty losses are treated as fully usable “business deductions” for these purposes.)
(5) Finally, “business” capital losses can only be used against “business” capital gains, except that if you still have nonbusiness capital gains after netting nonbusiness capital losses and excess nonbusiness deductions against them, you can use your business capital losses against them.
Example. N has a loss of $20,000 from business operations for the year. N also has (i) nonbusiness capital gains of $9,000 and nonbusiness capital losses of $4,000, and (ii) nonbusiness income of $13,000 and nonbusiness deductions of $14,000 (not including personal or dependency exemptions). N has no business capital gains or losses.
N’s “starting point” for calculating N’s NOL is N’s $20,000 business loss. N’s capital losses reduce N’s capital gains to $5,000 ($9,000 − $4,000). N’s nonbusiness deductions wipe out N’s nonbusiness income ($13,000 − $14,000), leaving N with $1,000 “excess” nonbusiness deductions. N can use the $1,000 excess nonbusiness deductions to further reduce N’s capital gains to $4,000. But, the $4,000 of capital gains do reduce N’s NOL from $20,000 to $16,000. The final result: N incurs a $16,000 NOL for the tax year.
Note that N’s taxable income will show a loss that’s greater than N’s $16,000 NOL, because N’s taxable income includes items such as personal exemption that aren’t allowed in figuring N’s NOL. Only the $16,000 NOL, however, can be carried forward to other years for use as a deduction.
The above computations can grow quite complex, depending upon your circumstances.
In addition to the rules above, special rules allow farmers to retain a pre-2018, two-year NOL carryback election and then applicable 80%-of-taxable-income limitation, for farming losses arising in 2018, 2019 or 2020 tax years, and to revoke a previously made waiver of the two-year carryback for 2018 or 2019 farming losses, and apply the five-year carryback instead. Obviously, there’s a lot to consider in determining the amount of your NOL, and whether to claim an NOL deduction. Please contact us today and we will be happy to discuss further.
Individuals must pay 25% of a “required annual payment ” by Apr. 15, June 15, Sept. 15, and Jan. 15, to avoid an underpayment penalty. When that date falls on a weekend or holiday, the payment is due on the next business day.
The required annual payment for most individuals is the lower of 90% of the tax shown on the current year’s return or 100% of the tax shown on the return for the previous year. However, if the adjusted gross income on your previous year’s return was over $150,000 (over $75,000 if you are married filing separately), you must pay the lower of 90% of the tax shown on the current year’s return or 110% of the tax shown on the return for the previous year.
Most people who receive the bulk of their income in the form of wages satisfy these payment requirements through the tax withheld by their employer from their paycheck. Those who make estimated tax payments generally do so in four installments. After determining the required annual payment, they divide that number by four and make four equal payments by the due dates.
But you may be able to use the annualized income method to make smaller payments. This method is useful to people whose income flow is not uniform over the year, perhaps because of a seasonal business. For example, if your income comes exclusively from a business that you operate in a resort area during June, July, and August, no estimated payment is required before Sept. 15. You may also want to use the annualized income method if a significant portion of your income comes from sales of securities that are made at various times during the year.
If you fail to make the required payments, you may be subject to an underpayment penalty. The penalty equals the product of the interest rate charged by IRS on deficiencies, times the amount of the underpayment for the period of the underpayment.
However, the underpayment penalty doesn’t apply to you:
(1) if the total tax shown on your return is less than $1,000 after subtracting withholding tax paid;
(2) if you had no tax liability for the preceding year, you were a U.S. citizen or resident for that entire year, and that year was 12 months;
(3) for the fourth (Jan. 15) installment, if you file your return by that Jan. 31 and pay your tax in full; or
(4) if you are a farmer or fisherman and pay your entire estimated tax by Jan. 15, or pay your entire estimated tax and file your tax return by Mar. 1
In addition, IRS may waive the penalty if the failure was due to casualty, disaster, or other unusual circumstances and it would be inequitable or against good conscience to impose the penalty. The penalty can also be waived for reasonable cause during the first two years after you retire (after reaching age 62) or become disabled. Third quarter estimated taxes for 2022 are coming due on September 15th. If you think you may be eligible to determine your estimated tax payments under the annualized income method, or you have any other specific questions about how the estimated tax rules apply to you, please contact our office today!
Are you thinking about setting up a retirement plan for yourself and your employees, but are concerned about the financial commitment and administrative burdens involved in providing a traditional pension or profit-sharing plan? An alternative program you may want to consider is a “simplified employee pension,” or SEP.
SEPs are intended as an alternative to “qualified” retirement plans, particularly for small businesses like yours. The relative ease of administration and the complete discretion you, as the employer, are permitted in deciding whether or not to make annual contributions, are features that are especially attractive. Here’s how these plans work.
If you don’t already have a qualified retirement plan, you can set up a SEP simply by using the IRS model SEP, Form 5305-SEP. By adopting and implementing this model SEP, which doesn’t have to be filed with the IRS, you will have satisfied the SEP requirements. This means that you, as the employer, will get a current income tax deduction for contributions you make on behalf of your employees. Your employees will be taxed not when the contributions are made, but at a later date when distributions are made, usually at retirement. Depending on your specific needs, an individually-designed SEP-instead of the model SEP-may be appropriate for you.
When you set up a SEP for yourself and your employees, you will make these deductible contributions to each employee’s IRA, called a SEP-IRA, which must be IRS-approved. The maximum amount of deductible contributions that you can make to an employee’s SEP-IRA, and that he or she can exclude from income, is the lesser of: (i) 25 percent of compensation, and (ii) $61,000 (for 2022). The deduction for your contributions to employees’ SEP-IRAs isn’t limited by the deduction ceiling applicable to an individual’s own contribution to a regular IRA. Your employees control their individual IRAs and IRA investments, the earnings on which are tax-free.
There are other requirements which you have to meet to be eligible to set up a SEP. Essentially, all regular employees must elect to participate in the program, and contributions can’t discriminate in favor of the highly compensated employees. But these requirements are minor compared to the bookkeeping and other administrative burdens connected with traditional qualified pension and profit-sharing plans. The detailed records that traditional plans must maintain to comply with the complex nondiscrimination regulations aren’t required for SEPs. And employers aren’t required to file annual reports with IRS-Forms 5500-which, for a pension plan, could require the services of an actuary. What record-keeping is required can be done by a trustee of the SEP-IRAs-usually a bank or mutual fund.
We are happy to meet with you to explain your SEP options in greater detail as well as answer any questions you may have. Give us a call today!
If you are planning to make a relatively substantial contribution to a charity, college, etc., you should consider donating appreciated stock from your investment portfolio instead of cash. Your tax benefits from the donation can be increased and the organization will be just as happy to receive the stock.
This tax planning tool is derived from the general rule that the deduction for a donation of property to charity is equal to the fair market value of the donated property. Where the donated property is “gain” property, the donor does not have to recognize the gain on the donated property. These rules allow for the “doubling up,” so to speak, of tax benefits: a charitable deduction, plus avoiding tax on the appreciation in value of the donated property.
Example: Tim and Tina are twins, each of whom attended Yalvard University. Each plans to donate $10,000 to the school. Each also owns $10,000 worth of stock in ABC, Inc. which he or she bought for just $2,000 several years ago.
Tim sells his stock and donates the $10,000 cash. He gets a $10,000 charitable deduction, but must report his $8,000 capital gain on the stock.
Tina donates the stock directly to the school. She gets the same $10,000 charitable deduction and avoids any tax on the capital gain. The school is just as happy to receive the stock, which it can immediately sell for its $10,000 value in any case.
Caution: While this plan works for Tina in the above example, it will not work if the stock has not been held for more than a year. It would be treated as “ordinary income property” for these purposes and the charitable deduction would be limited to the stock’s $2,000 cost.
If the property is other ordinary income property, e.g., inventory, similar limitations apply. Limitations may also apply to donations of long-term capital gain property that is tangible (not stock), and personal (not realty).
Finally, depending on the amounts involved and the rest of your tax picture for the year, taking advantage of these tax benefits may trigger alternative minimum tax concerns.
If you’d like to discuss this method of charitable giving more fully, including the limitations and potential problem areas, please give us a call.
Under these rules, up to $250,000 of the gain from the sale of single person’s principal residence is tax-free. For certain married couples filing a joint return, the maximum amount of tax-free gain doubles to $500,000.
Like most tax breaks, however, the exclusion has a detailed set of rules for qualification. Besides the $250,000/$500,000 dollar limitation, the seller must have owned and used the home as his or her principal residence for at least two years out of the five years before the sale or exchange. In most cases, sellers can only take advantage of the provision once during a two-year period.
However, a reduced exclusion is available if the sale occurred because of a change in place of employment, health, or other unforeseen circumstances where the taxpayer fails to meet the two-year ownership and use requirements or has already used the exclusion for a sale of a principal residence in the past two years. A sale or exchange is by reason of unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer does not anticipate before purchasing and occupying the residence. Unforeseen circumstances that are eligible for the reduced exclusion include involuntary conversions, certain disasters or acts of war or terrorist attacks, death, cessation of employment, change of employment resulting in the taxpayer’s inability to pay certain costs, divorce or legal separation, multiple births from the same pregnancy, and events identified by IRS as unforeseen circumstances (for example, the September 11 terrorist attacks). The amount of the reduced exclusion equals a fraction of the $250,000/$500,000 dollar limitation. The fraction is based on the portion of the two-year period in which the seller satisfies the ownership and use requirements.
These rules can get quite complicated if you marry someone who has recently used the exclusion provision, if the residence was part of a divorce settlement, if you inherited the residence from your spouse, if you sell a remainder interest in your home, if there are periods after 2008 in which the residence isn’t used as your (or your spouse’s) principal residence, or if you have taken depreciation deductions on the residence. Also, the exclusion does not apply if you acquired the residence within the previous five years in a “like-kind” exchange in which gain was not recognized.
Let us know if you have any questions about the exclusion or would like additional information. We are happy to go over the specifics of your situation with you to determine whether a sale of your residence would qualify for this valuable tax break.