Tax Breaks for Home Sellers with Disabilities

If you’re just joining us, part one of this series covered medical-expense deductions for people with disabilities, and part two focused on deductibility of costs associated with schooling children with physical or mental disabilities.

This article, part three, will focus on the profit exclusions that allow home sellers with disabilities to eschew federal and state income taxes on sizable portions of their profits from sales of their principal residences.

Exclusions top off at $500,000 for married couples filing joint returns, dropping to $250,000 for single persons or married couples filing separate returns. A home seller qualifies only if she owns and uses her home as a principal residence for periods aggregating at least two years out of the five-year period that ends on the sale date.

Exception to the use test for sellers with disabilities. There’s a limited exception to the use test, which authorizes a more easily satisfied test for sellers with disabilities, provided they meet two requirements:

• The person becomes physically or mentally unable to care for herself at any time during the five-year period that terminates on the sale date. 
• The person has to live in a nursing home or other facility that’s licensed by a state or other governmental unit to care for people with disabilities.

The exception for nursing-home care allows the home seller to meet the use test as long as she lived in her home as her principal residence for a total of at least one year during the five-year period. In other words, it allows her to spend up to four of the five required years in a nursing home and still qualify for the full profit exclusion.

However, the IRS says the home seller can’t lower the use-time requirement to one year by moving out of her home into the home of someone else, such as her adult son. This holds true even if she hires professional health care workers. Why? Because the son’s dwelling isn’t a “licensed care facility.” This is also true for some “assisted-living” arrangements.

The IRS defines a home seller as having a disability if she suffers from physical or mental disabilities that prevent her from dressing or feeding herself or tending to personal hygiene without the help of someone else, or if she needs constant attention to prevent her from injuring herself or others.

Making amends can bring rewards. Everyone makes mistakes; that’s why pencils have erasers. And that’s why there’s no need for your client to panic if she rechecks a Form 1040 after it was filed and discovers an error. Let’s say she overstated the gain from the sale of her home or overlooked the above exception to the use test that’s available to her and other sellers with disabilities. Generally, the paperwork to submit a refund claim for her overstatement isn’t burdensome. Your client would simply use Form 1040-X (formerly, Form 1040X) to explain the mistake and compute the refund due.

Deadline for filing 1040-X. While the statute of limitations, or deadline, limits the time for both your client and the IRS to make changes, the deadlines are fairly liberal. As a general rule, the deadline for your client to submit a 1040-X is within three years from the date she timely filed her original 1040 or two years from the time she paid the tax, whichever is later. The IRS will treat a 1040 that your client submitted early as though it was filed on the due date.

Let’s say your client wants to correct an erroneous 1040 for 2018 that she filed in February of 2019. Ordinarily, the cut-off date for filing a 1040-X is April 15, 2022. However, different rules kick in if she obtained an automatic, no-questions-asked six-month extension of the filing deadline from April 15, 2019, to Oct. 15, 2019. In that case, a three-year limit means that 2018’s return remains open for amendment until Oct. 15, 2022.

Exception to the three-year rule. The three-year window doesn’t apply to everyone. As with so many other code provisions, there are important exceptions. They include relief for your client and others during periods when they’re “physically or mentally unable to manage their financial affairs” due to serious physical or mental impairments, such as senility or chronic alcoholism, that can result in death or have lasted or can last longer than 12 consecutive months.

For joint filers, the IRS will approve a suspension when only one spouse is “financially disabled.” But it invokes the general rule and denies an extension when the person with disabilities has a spouse or someone else authorized to act on his or her behalf in financial matters––an agent named under a durable power of attorney, for example.

What’s next? Column four will focus on tax breaks created specifically for people with disabilities.