by Bob Rywick
The Internal Revenue Service has issued final and temporary regulations on the home sale exclusion that are effective for sales and exchanges after Dec. 23, 2002. However, taxpayers may elect to apply the regulations retroactively to sales or exchanges after May 6, 1997. These regulations provide interpretations of the home sale exclusion rules that are generally favorable to taxpayers.
The home sale exclusion allows an individual taxpayer to exclude as much as $250,000 of gain from the sale of a home owned and used by him as a principal residence for at least two of the five years before the sale. Married taxpayers filing jointly for the year of sale may be able to exclude up to $500,000 of home-sale gain.
The full exclusion doesn’t apply if, within the two-year period ending on the sale date, there was another home sale by the taxpayer to which the exclusion applied. However, a partial exclusion is allowed in some circumstances even if the two-of-five year use and ownership requirement is not met, or it has been less than two years since the last sale of a principal residence to which the exclusion applied.
In this column, the first of three, I will discuss the definition of a principal residence, including when vacant land is treated as part of the principal residence.
In my next column, I will discuss how excludible gain is determined on the sale of a principal residence that is partly used for business purposes.
In the last column, I will discuss when a partial exclusion will be allowed where the requirements for a full exclusion are not met.
Principal residence defined
The final regs say that the determination of whether a property is used by a taxpayer as a principal residence depends on all the facts and circumstances. If a taxpayer spends part of his time in two different residences, his principal residence ordinarily is the home where he spends a majority of the time during the year.
In addition to the taxpayer’s use of the property, other key factors in deciding whether a property is his principal residence include:
- Where he is employed;
- Where members of his family live;
- His address as shown on income tax returns, driver’s licenses, and auto and voter registration;
- His mailing address for bills and correspondence;
- Where he has bank accounts; and,
- Where he has memberships (e.g., places of worship, clubs, etc.).
Courts used these same factors to determine whether a taxpayer has used his home as a principal residence under prior law’s home sale exclusion for age 55 and older taxpayers, and for the rollover of home sale gain that was allowed under former IRC § 1034.Example 1: Your client owned two residences, one in Chicago and one in Palm Springs, Calif., throughout the five-year period from Jan. 1, 1998, through Dec. 31, 2002. She lived in the Chicago residence for five months of each of those years and in the Palm Springs residence for seven months of each of those years.
In the absence of facts and circumstances indicating otherwise, the Palm Springs residence is your client’s principal residence. Thus, she would be eligible for the home sale exclusion if she sells the Palm Springs residence, but not if she sells the Chicago residence.
Observation: In Example 1, your client would probably have a good chance of having the Chicago residence treated as her principal residence even if she resided seven months each year in the Palm Springs residence if:
- She worked throughout the five-month period she resided in Chicago, but did not work at all while she resided in Palm Springs;
- She showed her Chicago residence as her address on income tax returns, her driver’s license and her automobile registration;
- She had all of her funds deposited in banks in Chicago (including automatic deposits of her pension and Social Security checks);
- She belonged to a church in Chicago, but not in Palm Springs; and,
- Her unmarried son and daughter lived in the Chicago residence the entire year.
Example 2: The same facts apply as in Example 1, except that your client owned and resided in the Chicago residence for all of 1998 and 1999, owned and resided in the Palm Springs residence for all of 2000 and 2001, and owned and resided in the Chicago residence for all of 2002.She would be eligible for the full home sale exclusion on the sale of either of the residences at any time in 2003 regardless of which residence she resides in during 2003. This is because she would have owned and resided in each of the residences for at least two years in the five-year period ending on the date of the sale. However, she would not be eligible for the full exclusion if she sold both residences in 2003.
Observation: A taxpayer may elect not to have the home sale exclusion apply to a sale even if all the requirements for the exclusion have been met.
Example 3: The same facts apply as in Example 2, plus your client is a single individual who sells the Palm Springs residence in January of 2003 and has a gain of $120,000 on the sale. She then sells the Chicago residence in April of 2003 and has a gain of $230,000 on the sale.
She is not eligible to exclude the full gain on both sales since the second sale takes place only three months after the first sale. Accordingly, she should elect not to have the home sale exclusion apply to the gain on the sale of Palm Springs residence so that she will be eligible to exclude the larger gain on the sale of the Chicago residence.
When vacant land is treated as part of principal residence. The final regs also provide that gain on the sale of vacant land may be excluded if the land is owned and used as part of the principal residence, but only if:
- The sale or exchange occurs within two years (before or after) of the sale of the dwelling unit; and,
- The vacant land is adjacent to land containing the dwelling unit.
Only one maximum exclusion of $250,000 ($500,000 for qualifying joint filers) applies to the combined sales or exchanges of the vacant land and dwelling unit.If a dwelling unit and vacant land are sold or exchanged in separate transactions that qualify for the home sale exclusion, each of the transactions is disregarded in applying the rule restricting the exclusion to one sale or exchange every two years to the other separate transactions.
However, the separate transactions are taken into account in determining whether the sale of another principal residence was made within two years.
Sale or exchange of vacant land before dwelling unit.
If the land is sold in a year before the dwelling unit is sold, and the dwelling unit is not sold before the due date of the taxpayer’s tax return for the year in which the land is sold, gain must be recognized on the taxpayer’s tax return for that year.
However, if the dwelling unit is later sold, and the period for filing a refund claim for the year in which the land was sold is still open, the taxpayer may file an amended return to claim a refund of the tax paid on the gain on the sale of the land
Example 4: On April 1, 1995, your client, a single taxpayer, bought property consisting of an eight-room house and seven acres of land. She has used that property as her principal residence since she bought it. In August 2001, she sold five acres of the land and realized a gain of $50,000 on the sale.
Your client did not sell the house before the due date for filing her 2001 return. Accordingly, she was not eligible to exclude the $50,000 of gain on that return. In March of 2003, she sells the house and the remaining two acres of land. She has a gain of $150,000 on that sale. She may exclude the $150,000 of gain.
Because the sale of the five acres occurred within two years from the date of the sale of the house, the sale of the five acres is treated as a sale of her principal residence. Your client may file an amended return for 2001 to claim an exclusion of the gain of $50,000 on the sale of the five acres since the later sale took place less than two years after the first sale.
The full $50,000 is excludible since this is less than the difference between $250,000 (the maximum allowable exclusion) and the gain of $150,000 on the sale of the house and the remaining two acres of land.
Example 5: The same facts apply as in Example 4, except that the gain on the sale of the house and two acres of land is $210,000. Your client will only be able to exclude $40,000 of the gain on the sale of the five acres on an amended return ($250,000 less the $210,000 gain on the sale of the house and the remaining two acres).
Suppose a taxpayer has a loss on one sale (e.g., the sale of the vacant land) and gain on the other sale that is more than the allowable exclusion (e.g., the sale of the dwelling unit). An example in the final regs says that the taxpayer may combine the loss and gain to determine the excludable amount, at least where both sales occur in the same year.
Observation: Since sales made within two years of a dwelling unit and vacant land that are treated as one principal residence are treated as one sale, it would seem that a loss on one sale should offset gain on the other even if it is not made within the same year. The final regulations are not specific on this point, however.
Example 6: In 1998, your client buys a house and two acres of land that he uses from the date of purchase until March 1, 2002. In 1999, he buys an additional 18 acres adjacent to his house and uses the vacant land as part of his principal residence.
On April 15, 2002, your client sold the house and the original two acres at a loss of $20,000. On Nov. 15, 2002, he sold the other 18 acres at a gain of $260,000. His combined gain from the two sales is $240,000.
He may exclude the entire combined gain of $240,000. If he were not allowed to combine the gain and loss, he would have to report taxable gain of $10,000 on the sale of the 18 acres ($260,000 less exclusion of $250,000) and would have a nondeductible loss of $20,000 on the sale of the house and two acres.
Example 7: The same facts apply as in Example 6, plus your client bought a new house that he uses as his principal residence starting on March 1, 2002. Assume that he continues to use the house as his principal residence until he sells it on Oct. 1, 2004, at a gain of $80,000.
He will not be able to exclude the full amount of the gain from the sale since this sale took place less than two years after the Nov. 15, 2002, sale of the 18 acres of land since that sale was treated as a sale of his principal residence. Whether he could exclude any part of the gain would depend on whether he qualified for a partial exclusion.
