In Part II, we discussed the "owned and used" rules and the "two year" rules as they apply to single people. In this, the concluding installment, we'll look at these rules relative to married people.

A married couple filing a joint return for the year of the home sale may exclude up to $500,000 of their home sale gain if:

1. Either spouse owned the home for at least two years in the five-year period ending on the sale date; and

2. Both spouses used the home as a principal residence for at least two years in the five-year period ending on the sale date; and

3. Neither spouse had used the new exclusion on the sale of another residence within the two-year period ending on the date of the current home's sale.

Example 1: Jack had owned his home and used it as his principal residence for the last 10 years. In February 1997, Jack met and married Jill. Jill moved into Jack's home, and Jack also transferred half ownership of the home to Jill at that time. In January 1998, Jack and Jill sold the home. They will NOT qualify for the full exclusion since BOTH spouses did not use the home as a principal residence for the two-year period (number 2 above). Jill only lived in the home for a little less than a year. This problem could have been avoided simply by holding on to the home until March of 1999 when the two-year use rule would have been met.

Example 2: Tom and Mary fell in love in 1990… but held off getting married at that time. In 1991, Tom and Mary purchased a home together and lived there as their principal residence. In November 1997, Tom and Mary got married. And in December 1997, they sold their home. Tom and Mary WILL qualify for the full $500,000 exemption. All of the qualifications have been met… even though they may not have been married during the qualifying period. The law simply says that items 1 through 3 must be met and a joint return must be filed. It does not say that you must be married during the entire time of home ownership and use.

Example 3: John has owned his principal residence since 1980. In 1995, John and Kathy got married and settled into John's home. John did NOT transfer one-half ownership of the home to Kathy. In 1998, John and Kathy sold the home. They WILL qualify for the full exclusion, since all of the qualifications are met. Please note in qualification number 1 above that EITHER spouse must own the home for the two-year period. Even though Kathy never owned the home, the fact that John did and that they both used the home for more than two years means that the qualifications have been met.

Example 4: Brian bought his principal residence in 1985. Holly bought hers in 1987. In 1994, Brian and Holly met and fell in love. In 1994, Holly moved into Brian's home. Since Holly didn't know if the relationship would last, she decided to keep her home, but leave it vacant just in case. In 1996, Holly knew it was true love and decided to sell her home. She did, and took the $250,000 exclusion allowed for a single person. In 1997, Brian and Holly got married and decided to sell the home that they had been living in since 1994. They will NOT receive the full exclusion, since they were in violation of qualification number 3 above in that Holly used an exclusion within two years of selling the current residence. If Holly had sold her home earlier, or if they had waited until 1998 to sell their joint home, they would have qualified for the full exclusion.

Example 5: Bob and Sue decided to split the sheets. In December 1995, Bob moved out of the home that they had both purchased in 1994. The divorce proceedings got ugly and complicated, and dragged on and on. While still legally married, Bob and Sue sold the home in November 1997. And even though they filed a joint tax return for 1997, they will not receive the benefit of the full exclusion. Why? Because Bob did not use the home as his principal residence for at least two of the five years prior to the sale (qualification number 2 above).

As you can clearly see, some planning is required when spouses meet, fall in love, and get married -- or fall out of love and get divorced. Proper planning can save hundreds of thousands of tax dollars. Improper planning can cost you just as much.

So what happens if you don't meet the qualifications? Does that mean that you lose your entire exemption? Nope. Not necessarily. But your exemption will be limited based upon an IRS formula. While I'll explain the computations for the reduced exemption, but you might find it easier to first check out the IRS website and download IRS Form 2119. You'll find that Form 2119 has a nice little worksheet and instructions that will help you walk through the computations. Regardless, here is how it works… step by step:

1. During the five-year period ending on the sale date, determine the number of days the spouse (a) used the home as his/her principal residence, and (b) the number of days the spouse owned the home. When looking at the home ownership days, remember that if one spouse owned the property longer than the other, BOTH spouses are treated as owning the property for the longer period of time. Nevertheless, enter the smaller of the result of (a) or (b). If the result is more than 730 days, use a maximum number of days of 730.

2. Divide the result in (1) above by 730 days (representing two full years).

3. Multiply the result in (2) by $250,000.

You make the above computation for EACH spouse. Once you have completed the computations for each spouse, add the result for each in (3) above. The joint exclusion is the lesser of the actual gain on the sale or the total of their combined separate exclusions under the above formula.

Example: Jack has owned his home and used it as his principal residence for 20 years. On March 1, 1997 he married Jill, and on March 1, 1998 he sold the property for a gain of $400,000. Jill moved into Jack's home on their wedding day, and Jack transferred half ownership of the home to her at that time.

Jack and Jill would be able to exclude $375,000 of gain, and the remaining $25,000 gain would be subject to tax. The computations look like this: