Finally, it appears that the Internal Revenue Service has had its say for a while on the rules governing the sale of a principal residence.
It’s been over six years since Congress enacted the $250,000 exclusion ($500,000 for joint filers) on the gain from the sale of a principal residence. This past month, the IRS issued final regulations on what is thought to be the end of the final regs process for the exclusion. For the upcoming year, the IRS Priority Guidance Plan has scheduled only one piece of guidance on the sale of a residence: a revenue ruling on like-kind exchanges.
Based on the final regs, as supplemented by other IRS guidance over the past several years, clear tax strategies have emerged for the homeowner. However, gray areas still exist and need to be noted.
Here is a review of some of those strategies, and the “tips and traps” that go with them.
Background
Homeowners may exclude from gross income up to $250,000 (or $500,000 for most marrieds filing jointly) of the gain realized on the sale or exchange of property that they have owned and used as their principal residence for periods aggregating at least two out of the five years ending on the date of the sale or exchange.
The five-year test period can be suspended for up to 10 years for absences due to service in the uniformed services or the foreign service of the United States. The most often a taxpayer may use this provision is once every two years — that is, once during the two-year period ending on the date of the sale or exchange.
Vacation homes
The fact that the excluded gain does not need to be traced to the period during which the taxpayer maintained the property as a principal residence creates an advantage for vacation homeowners, especially for those approaching retirement with the flexibility to move anywhere. As long as the taxpayer makes the vacation home a principal residence, an exclusion is permitted even though most of the gain may be attributed to years of ownership before the property became a principal residence.
Under the ideal scenario, a couple sells their principal residence in the city for a $500,000 profit, then moves into their beach house of 30 years for two years, then sells that property for a $500,000 gain. As a result, they pay no tax on the $1 million gain, rather than $150,000 in maximum capital gain tax.
- Business/residential use. Even if the vacation home had been rented out over the years, no allocation of gain from the sale or exchange of mixed-use property is required if both the residential and business portions of the property are within the same dwelling unit. Only that portion of any prior depreciation taken on the property characterized as unrecaptured post-May 6, 1997, Section 1250 gain must be recognized and cannot be excluded.
- Principal residence. Whether a property qualifies as the taxpayer’s residence and whether she uses the property as her principal residence turns on the facts and circumstances of each case. Relevant factors in determining the taxpayer’s principal residence include the taxpayer’s place of employment; the principal place where the taxpayer’s family lives; the address used by the taxpayer on tax returns, driver’s licenses, and automobile and voter registrations; the mailing address used for bills; and the location of the taxpayer’s banks, house of worship and social clubs.
Unfortunately, the IRS does not rule in advance on whether a residence qualifies as a principal residence.Entity ownership
In certain instances, ownership of a principal residence by an entity, rather than by an individual, will still satisfy the two-year ownership requirement for exclusion of gain. This rule applies to ownership of the residence by grantor trusts and single-owner entities that are disregarded for federal tax purposes as an entity separate from its owner.
However, individuals will not be treated as owning a residence for the period of time that the residence is owned by a partnership in which they are general partners.
Record-keeping
One stated reason for the principal residence gain exclusion has been the burdensome record-keeping that taxpayers faced for many years in tracking their residential bases for home improvements, casualties and the like.
However, record-keeping is beginning to be seen as a worthwhile burden again for many taxpayers. The instances in which basis record-keeping is useful include:
- Computing the gain when the gain on the sale price exceeds the maximum exclusion, or the taxpayer is entitled only to a partial exclusion (the exclusion is not adjusted for inflation and many homeowners find themselves butting up against the $250,000 or $500,000 exclusions that seemed so generous back in 1997 when they were first introduced);
- Conversion of part or all of the property to business use, and subsequent depreciation and like-kind exchanges;
- Gifts;
- Divorce; and,
- Involuntary conversions.
Partial exclusion of gain
A partial maximum exclusion of gain may be available even if a taxpayer does not meet the minimum two-year ownership and use requirements. For a partial exclusion to be available, however, the sale must occur by reason of a change in place of employment, health or, to the extent to be prescribed by regulations and other guidance, other unforeseen circumstances. Otherwise, the exclusion when selling in fewer than two years is zero.Generally to the taxpayer’s advantage, the exclusion is a pro-rata portion of the maximum $250,000/$500,000 amount, rather than a portion of the total actual gain otherwise excluded. Thus, a qualifying single taxpayer using and owning the property as a principal residence for one year with a gain of $100,000 will be able to exclude the entire $100,000, rather than half, since the maximum pro-rata exclusion is $125,000.
A number of safe harbors have been provided under final regs that allow a taxpayer to claim a partial exclusion by reason of a change in place of employment, health or unforeseen circumstances without having to prove that it constituted the primary reason for the sale.
- Employment safe harbor. Employment is broadly defined as employment with a new employer, continuing employment with the same employer, or beginning or continuing self-employment. Under the safe harbor, the primary reason for a sale or exchange is deemed to be a change in place of employment where the qualified individual’s new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment.
It should be noted that this safe harbor puts those who presently are long-distance commuters at a disadvantage, since the new commute, depending upon its path, may need to be 50 miles longer than the old one to qualify for the partial exclusion. If the person is already traveling 45 miles, that may become quite a trip — with up to 189 miles of roundtrip not qualifying.
- Health safe harbor. A sale or exchange is by reason of health if the primary reason is to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury of a qualified individual (taxpayer, spouse, co-owner or member of household as dependent or relative), or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness or injury. A sale or exchange that is merely beneficial to the general health of the individual is not a sale or exchange by reason of health.
Under the safe harbor, the primary reason for a sale or exchange is deemed to be health-related if a physician recommends a change of residence for reasons of health. Since it is generally more straightforward to have a physician agree that health requires a move than it is to get the IRS to draw that conclusion, a physician’s written statement that repeats the statutory language in some form should be obtained.
- Separate nursing home rule. If a taxpayer becomes physically or mentally incapable of caring for himself but meets the ownership and use requirements for periods aggregating at least one out of the five years ending on the date of the sale or exchange, he is deemed to have used the property as his principal residence during any time in the five years that he resides in any facility, including a nursing home, licensed by a state or political subdivision to care for people in such condition. If this test is met, a full maximum $250,000/$500,000 exclusion is available. If ownership and use is less than one year, or if the medical condition forces the taxpayer to move into a friend or relative’s home, the taxpayer must use the regular reduced maximum exclusion rules.
- Unforeseen circumstances safe harbor. 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 could not reasonably have anticipated before purchasing and occupying the residence. The final regs last month clarified that a sale or exchange by reason of unforeseen circumstances does not qualify for the partial exclusion if the primary reason for the sale or exchange is merely a preference for a different residence or an improvement in financial circumstances.
Under the safe harbor for unforeseen circumstances, a sale or exchange is deemed to be by reason of unforeseen circumstances if due to involuntary conversion; casualty; death of a qualified individual; cessation of employment; change in employment or self-employment status that results in the qualified individual’s inability to pay housing costs and reasonable living expenses; divorce or legal separation; multiple births; or other events or situations determined by the IRS under published public guidance.Marriage or adoption is not deemed a sufficient trigger for the safe-harbor exception. However, each taxpayer may use a facts-and-circumstances test to show that their marriage or adoption does qualify as the primary reason for an early sale.
Marital status
For married taxpayers filing a joint return, the $500,000 exclusion applies if either spouse meets the two-year ownership requirement, both spouses meet the two-year use requirement, and neither spouse is ineligible by reason of the rule prohibiting the use of the exclusion more than once every two years.
When married taxpayers do not qualify for the $500,000 exclusion because one of these conditions is not met, the amount of the exclusion that may be claimed by the couple is the sum of the $250,000 maximum exclusion to which each spouse would be entitled if such spouses had not been married. This may be the case, for example, when recently married taxpayers each have a separate premarital residence that qualifies for the exclusion.
- Death. If the spouse of a taxpayer is deceased and the taxpayer has not remarried on the date of the sale or exchange, the taxpayer’s ownership and use periods include those of the deceased spouse for purposes of fulfilling the ownership and use requirements.
However, there remains a question as to whether such a taxpayer can only obtain the $500,000 maximum exclusion for married taxpayers filing jointly if the principal residence was sold during the tax year of the spouse’s death and the taxpayer files a joint return for that year with the personal representative of the deceased spouse’s estate. The status of filing as a surviving spouse is not the same as the married-filing-jointly status technically required for the higher exclusion.
- Divorce. If property is transferred to a spouse, or to a former spouse incident to a divorce, the period that the transferee spouse owns the property includes the period that the property was owned by the transferor spouse. In addition, and only for purposes of this gain exclusion, a taxpayer is treated as using property as his principal residence during any period that the taxpayer’s spouse or former spouse is granted actual use of the property under an instrument of divorce or separation.
Conclusions
The rules for the sale of a principal residence are now out there in as much detail as we are going to get for the most part for the next several years.Proving principal residence probably will require extra attention to detail by those vacation-homeowners who only want to live in a particular property to win an exclusion. Keeping track of tax basis for home renovations, etc., remains a good idea for homeowners.
If a taxpayer is moving before residing in his property for more than two years, the antennae should go up to make sure that certain facts are gathered and saved to substantiate qualification for one of the exceptions that allows for a partial exclusion. Preferably, the homeowners will qualify under a safe harbor but, if need be, they should be prepared to pass the more dicey facts-and-circumstances test.
George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., in Riverwoods, Ill.
