|EXECUTIVE SUMMARY |
| TO EXCLUDE GAIN ON THE DISPOSITION OF A HOME from income under IRC section 121, a taxpayer must own and occupy the property as a principal residence for two of the five years immediately before the sale. However, the ownership and occupancy need not be concurrent. The law permits a maximum gain exclusion of $250,000 ($500,000 for certain married taxpayers). The IRS has issued proposed regulations to clarify how these rules work in certain situations.
A TAXPAYER IS CONSIDERED TO HAVE OWNED and used a home as a principal residence during the time his or her deceased spouse used the home as a principal residence. This rule applies as long as on the day the home is sold the taxpayer’s spouse is deceased and the taxpayer has not remarried. Divorced spouses can also benefit from the ownership and use periods of former spouses to satisfy the exclusion requirements.
TAXPAYERS MUST RECOGNIZE GAIN ON ANY portion of a residential property they don’t use for residential purposes. Any post-May 6, 1997 depreciation allowable on the property triggers recognition of otherwise excludable gain.
A TAXPAYER CAN GENERALLY CLAIM ONLY ONE exclusion every two years. However, a taxpayer who disposes of more than one residence within two years or who otherwise fails to satisfy the requirements, for example due to a job change or health problem, may qualify for a reduced exclusion amount.
|NANCY J. FORAN, CPA, PhD, was associate professor of accounting at the University of Michigan at Dearborn. She died in February 2002. JEFFREY J. BRYANT, CPA, JD, PhD, is associate professor of accounting at Wichita State University in Kansas. His e-mail address is email@example.com . |
or many taxpayers their residence is their most valuable asset. With the continuing increase in home prices, the gain realized on a sale could be significant. Provisions of the Taxpayer Relief Act of 1997 allow most to exclude from income the gain on the sale of a home without even reporting the transaction on their tax returns. Proposed regulations clarify the requirements for excluding the gain from income and give CPAs opportunities to suggest new tax planning strategies to their clients.
IRC section 121 allows a taxpayer to exclude up to $250,000 ($500,000 for certain taxpayers who file a joint return) of the gain from the sale (or exchange) of property owned and used as a principal residence for at least two of the five years before the sale. A taxpayer can claim the full exclusion only once every two years. A reduced exclusion is available to anyone who does not meet these requirements because of a change in place of employment, health or certain unforeseen circumstances. Unlike under former law, the gain on the sale of a house is now permanently excluded, rather than deferred, and a taxpayer doesn’t have to purchase a replacement home to exclude the gain.
|If a taxpayer excludes the entire gain on the sale from income, the transaction is not reported on his or her tax return. If any part of the gain is taxable, he or she reports the sale on schedule D of form 1040. Alternatively, a taxpayer can elect to include the gain from a sale by reporting it on his or her tax return. For example, someone who realizes gains on the sale of two principal residences within two years can exclude the gain on only one. Most would want to recognize the smaller gain and exclude the larger. Since the exclusion applies automatically to the first disposition, a taxpayer would need to elect to be taxed on this one if it is the smaller of the two.
|Home Ownership by the Numbers |
In early 2002 the home ownership rate in the United States was 67.8%, just slightly above the 65.5% rate in 1980.
Of the 122.9 million housing units in the United States, approximately 108.1 million are occupied—73.3 million by owners and the remainder by renters.
Source: U.S. Census Bureau, www.census.gov .
Principal residence requirement. The rules define the term residence fairly broadly—it includes a houseboat, house trailer or stock held by a tenant-stockholder in a cooperative housing corporation. Personal property that is not a fixture under local law will not qualify as a residence. Consequently, CPAs should consult local law, particularly on the status of mobile dwellings. If a taxpayer owns more than one home, practitioners will find the determination as to which home is the taxpayer’s principal residence depends on all of the facts and circumstances. The regulations say that the home a taxpayer uses for the majority of the time during the year will be considered his or her principal residence for that year.
Example. For the period 2000 to 2004, Albert owns a home in Michigan and a home in Florida. During each of these years, Albert lives in the Michigan home for seven months and in the Florida home for five months. If Albert decides to sell one of the homes in 2005, only the Michigan home will qualify for the gain exclusion. Because he lives in Michigan for the majority of each year, that home is Albert’s principal residence for 2000 to 2004.
Ownership and use requirements. The ownership and use requirements are based on the total number of days or months the taxpayer owns and uses the property as a principal residence during the five-year period ending on the date of disposition. The gain on the sale of a home is excluded from income only if, during that five-year period, the taxpayer owns and uses the property as a principal residence for periods totaling two years or more. Either 24 full months or 730 days will satisfy the two-year ownership and use requirements.
Example. On January 1, 1998, Barbara bought a home and began to live in it. On January 1, 2000 (24 months after purchasing the home), Barbara moved out of town and began to lease the home. On December 28, 2002, she sells the property. Because Barbara owned and used the home as a principal residence for 24 months during the five-year period ending on the date of sale, she is eligible for the gain exclusion. If, however, Barbara sells her house on February 1, 2003, the five-year period would have begun on February 1, 1998. In this case Barbara would not be eligible for the gain exclusion because she would have lived in the home for only 23 months during the five-year period before the date of sale.
The proposed regulations clarify that ownership and use periods do not need to be concurrent.
Example. Carmella rented a home from January 1, 1993 to January 1, 1998. She purchased the home on January 1, 1998 and lived in it until February 1, 1998. On March 1, 2000, Carmella sold the home. During the five-year period ending on the date of sale (March 1, 1995 to March 1, 2000), Carmella owned the home for at least two years (January 1, 1998 to March 1, 2000) and lived in it for at least two years (March 1, 1995 to February 1, 1998). Therefore, Carmella is eligible for the gain exclusion even though she did not live in the residence during the same two years she owned it.
If a taxpayer owns two homes during the five-year period, both may qualify for the exclusion if the taxpayer uses each of them as a principal residence for at least two years during the five-year period. However, as discussed below, CPAs will find that usually the gain on only one of the two otherwise qualified homes can be excluded during any two-year period.
Example. For the period January 1, 2000 to December 31, 2004, David owns a home in Kansas and also in Texas. David lives in the Kansas home during 2000, 2001 and 2004 and in the Texas home during 2002 and 2003. David’s principal residence for 2000, 2001 and 2004 is the Kansas property. His principal residence for 2002 and 2003 is the Texas home. If David decides to sell one of the homes during 2004, both qualify for the gain exclusion because he owned and used each one as a principal residence for at least two years during the five-year period before the sale date.
To satisfy the use requirement, the taxpayer must physically occupy the home. However, short temporary absences, such as vacations, are counted as periods of use even if the home is rented during that time.
Example. On January 1, 2000, Elvira bought and began to live in a home. During 2000 and 2001, Elvira went to England for June and July on vacation. She sells the home on January 1, 2002. Although during the five-year period ending on the date of sale (January 1, 1997 to January 1, 2002) Elvira occupied the home for only 20 of the 24 months she owned it (January 1, 2000 to January 1, 2002), the two months spent in England each year are counted as periods of use because they were short temporary absences. Therefore, Elvira is eligible for the gain exclusion. If, however, Elvira had spent June 1, 2000 to June 1, 2001 in England, she would not be eligible for the gain exclusion because a one-year absence is not treated as a short temporary one. In the latter case Elvira used the home for only 12 months during the five-year period ending on the date of sale.
Planning strategy. It is important that CPAs advise taxpayers to carefully document the time they spend at a home to ensure they meet the two-year ownership and use requirements. Delaying the sale until a taxpayer has met those requirements may result in significant tax savings. Documenting the time spent at a home is important for anyone owning more than one because only the primary residence is eligible for the gain exclusion. To determine which home qualifies as the taxpayer’s principal residence, the IRS is likely to make its standard inquiries. CPAs should advise clients to retain documentation such as travel receipts, change of mailing address, voter registration, utility bills, periods of employment and attendance at religious or social events that can help establish what constitutes a taxpayer’s main home. Taxpayers who plan to sell one home must spend enough time at that property to satisfy the primary residence and the ownership and use requirements.
Deceased spouse. For the ownership and use requirements, a taxpayer is considered to have owned and used a home as a principal residence during the time his or her deceased spouse owned and used the home (before death) as a principal residence as long as on the day the home is sold the taxpayer’s spouse is deceased and the taxpayer has not remarried.
Former spouse. In cases of divorce, taxpayers can benefit from both the ownership and use periods of former spouses to satisfy the requirements. If a taxpayer receives a home as part of a divorce property settlement, the taxpayer’s ownership period will include the time the spouse or former spouse owned the home. In addition a taxpayer is treated as having used the home as a principal residence during the time the taxpayer owned the residence and the taxpayer’s spouse or former spouse was permitted to use it—under a decree of divorce or separation—as a principal residence.
Example. On January 1, 2000, Harry bought a home and began to live in it with his spouse, Jennifer. On January 1, 2001, Harry and Jennifer were divorced. Under the divorce decree, Jennifer is allowed to live in the home until February 1, 2002. Harry sells the home on March 1, 2002. Harry and Jennifer could both meet the two-year ownership and use requirements. Although Harry lived in the home for only 12 months, if he continues to own it he is also considered to have lived in the home for the 13 months Jennifer lived there. If Jennifer owns the residence after January 1, 2001, her ownership period includes Harry’s ownership from January 1, 2000 to January 1, 2001.
Planning strategy. CPAs may want to recommend that divorcing homeowners who have not met the two-year ownership and use requirements consider having the divorce or separation decree require that one spouse remain in the home until the two-year use requirement is met.
SECTION 121 LIMITATIONS
The proposed regulations specify three major limits on a taxpayer’s ability to claim the section 121 exclusion:
Disallowance for use or partial use of the home as a nonresidence.
An overall dollar limitation.
The once-every-two-years limitation.
Disallowance for use as a nonresidence. If a taxpayer also uses a home for purposes other than as a principal residence, the gain exclusion does not apply to the extent of depreciation taken on the home after May 6, 1997.
Example. On January 1, 1998, Kelly bought a home and rented it to tenants for two years. During the rental period, Kelly takes depreciation deductions of $14,000. On January 1, 2000, Kelly moves into the home and begins to use it as a principal residence. On February 1, 2002, after owning and using the home as a principal residence for more than two years, he sells the home at a $40,000 gain. Only $26,000 ($40,000 realized gain minus $14,000 depreciation) of the gain is eligible for the exclusion. Kelly must recognize the remaining $14,000. For purposes of IRC section 1(h), the gain is an unrecaptured IRC section 1250 gain.
If a taxpayer uses a home partially for business purposes, only the part of the gain attributable to the residential portion of the home is excluded from income. Also, the gain exclusion does not apply to the extent depreciation allowable after May 6, 1997, with respect to the home, exceeds the gain on the home allocable to the business-use portion. Therefore, pre-May 7, 1997 depreciation does not reduce the amount of gain excludable under section 121 on the residential portion in any circumstances. However, post-May 6, 1997 depreciation allowable on nonresidential use can trigger gain recognition on the residential-use part of the house.
Example. Leann used 10% of her home as an office for a business. She owned and used the home as a principal residence for at least two years during the five-year period before she sold it. The gain exclusion does not apply to 10% of the gain.
Example. On January 1, 1999, Morton bought a house that he used partially for business purposes. He sells the home on January 1, 2002 having owned and used it for three years. Morton realizes a $40,000 gain on the sale, of which $30,000 is attributable to the residential portion of the home and $10,000 to the business portion. His depreciation deductions on the home total $12,000. The gain on the residential portion of the home eligible for exclusion ($30,000) is reduced by $2,000—the amount by which the depreciation deductions exceed the gain on the business-use portion of the home ($12,000 depreciation minus $10,000 gain). Therefore, Morton will exclude $28,000 ($30,000 minus $2,000) from income but will include $12,000. For purposes of section 1(h), the $12,000 to be included in income is treated as unrecaptured section 1250 gain. However, if Morton had taken depreciation deductions of $7,000, the gain on the residential portion of the home eligible for exclusion ($30,000) would not be reduced because Morton’s depreciation deductions ($7,000) did not exceed the gain on the business-use portion of the home ($10,000). Therefore, he would exclude $30,000 from income but include $10,000.
Overall dollar limitation. The maximum gain exclusion for an individual taxpayer is $250,000. Taxpayers who jointly own a principal residence, but file separate returns, may each exclude up to $250,000 of the gain attributable to their interest in the home. A husband and wife who file a joint return may exclude up to $500,000 of the gain if
Either spouse meets the two-year ownership requirement.
Both spouses meet the two-year use requirement.
Neither spouse excluded gain from a prior sale or exchange of a principal residence within the last two years.
If the taxpayers do not meet any one of these requirements, the maximum exclusion amount a married couple can claim on a joint return is the sum of each spouse’s exclusion amount, determined as though (1) the spouses were not married and (2) each spouse owned the home during the period that either spouse owned the home. Although one spouse’s ownership is attributed to the other for purposes of determining a separately calculated exclusion, both spouses must actually use the house as a principal residence to qualify for their own $250,000 exclusion.
Example. Nancy and Oscar marry in 2001 and move into an apartment. The couple each separately owned and used a home for at least two years before marrying. Nancy and Oscar sell their separate homes in 2002. Nancy realizes a gain of $225,000 on the sale of her home and Oscar realizes a gain of $275,000 on his sale. Although Nancy and Oscar do not meet the requirements to exclude up to $500,000 of gain on their joint return, each spouse may exclude up to $250,000. Therefore, Nancy and Oscar will exclude $225,000 from the sale of Nancy’s home and $250,000 from the sale of Oscar’s home. Because Oscar cannot use any of Nancy’s unused exclusion, the couple must include $25,000 of the gain on his home in income. The result would be the same if Nancy and Oscar each had sold their homes before marrying.
Planning strategy. If a married couple each own a home before their marriage and one home could be sold at a gain that exceeds $250,000, CPAs should recommend the home that would result in the smaller gain be sold. If the couple then move into the home that could produce a gain in excess of $250,000 and live there for at least two years, the couple would qualify for the $500,000 exclusion as long as that sale does not occur within two years of the first sale. In the above example, if Nancy and Oscar sell Nancy’s home and live in Oscar’s home for at least two years before selling it, the entire $275,000 gain would be excluded from income if the house is sold at least two years after the sale of Nancy’s home.
If a married couple meet the ownership and use requirements to qualify for the $500,000 gain exclusion and one spouse dies, the $500,000 exclusion will continue to apply if the surviving spouse sells the house in a year in which he or she can file a joint return with the deceased spouse. Further, if the surviving spouse has not remarried, both the deceased spouse’s ownership and use as a principal residence are attributed to the survivor.
Example. Peter and Quill, a married couple, have owned and used their home as a principal residence since 1998. Peter dies on June 1, 2002. On November 1, 2002, Quill sells the home at a $280,000 gain. The entire $280,000 is eligible for the gain exclusion if she files a joint return for 2002. If, however, Quill sells the home on January 10, 2003, only $250,000 of the gain is eligible for the exclusion because Peter and Quill cannot file a joint return in 2003.
Planning strategy. If a decedent was the sole owner of a home, the property’s basis will be its fair market value at the date of death. Therefore, under current law, any increase in value up to the date of death escapes income taxation and the gain exclusion would not be important. If the home is owned jointly, the basis of the decedent’s half of the home is its fair market value at the date of death. The increase in value on that half of the home escapes income taxation, and sale of the home in the year of death is relevant only if the surviving spouse’s share of the increase in value exceeds $250,000. If the home is wholly owned by the surviving spouse and the value of the home has increased by more than $250,000, selling it in the year of death would allow the surviving spouse to retain the $500,000 exclusion.
Once-every-two-years limitation. A taxpayer cannot use the gain exclusion if, during the two-year period ending on the date of the sale or exchange, he or she sold another home and excluded the gain on that home. However, as discussed below, a reduced exclusion may be allowed.
Example. Robert buys a home that he uses as a principal residence in 1999 and 2000. In 2001, he buys a condo that he uses as a principal residence in 2001 and 2002. He then sells the original home in 2002 and excludes that gain from income. If Robert sells the condo in 2003, he cannot exclude the gain on that sale—even though he satisfies the two-year ownership and use requirements—because he excluded the gain on the sale of the home within the prior two years.
Taxpayers who sell their principal residence but don’t meet the ownership and use requirements, or who sell their home within two years of selling another home, may be eligible for a reduced exclusion. The reduced exclusion is available if a change in place of employment, health or unforeseen circumstances necessitated the sale. Neither the Internal Revenue Code nor the proposed regulations define the change in place of employment, health problems or unforeseen circumstances that would allow taxpayers to qualify for the reduced exclusion.
CPAs would calculate the reduced exclusion by multiplying the maximum dollar limitation ($250,000 or $500,000 for qualifying married taxpayers) by a fraction. The numerator of the fraction is the shortest of (1) the time the taxpayer owned the home during the five-year period ending on the date of the home’s sale, (2) the time the taxpayer used the home during the five-year period ending on the date of sale or (3) the time between the date of the prior sale for which gain was excluded and the date of the current sale. The numerator and denominator are expressed in either days or months. If the measure is days, the denominator is 730 days (365 days X 2 years). If the measure is months, the denominator is 24 months.
Example. On January 1, 2001, Sally, an unmarried taxpayer, buys a home and uses it as a principal residence. On July 1, 2002, 18 months later, Sally sells the home because her employer transfers her to an office in another state. Sally may exclude up to $187,500 (250,000 X 18/24) of the gain on the sale of her home.
Example. On January 1, 1999, Tom buys and begins to live in a home. On January 1, 2001, Tom marries Ursula and she moves into Tom’s home. On January 1, 2002 (12 months after Ursula began residing in the home), they sell the home because their employers transfer them to another state. Because only Tom has satisfied the two-year use requirement, the couple cannot use the $500,000 exclusion. Rather, their exclusion is determined by calculating the limitation amount for each spouse as if they had not been married. Therefore, Tom can exclude up to $250,000 of gain because he meets both the ownership and use requirements. Although Ursula does not meet these use requirements, she can claim the reduced exclusion because the sale is due to a job change. Ursula can exclude up to $125,000 (250,000 X 12/24) of the gain. Therefore, Tom and Ursula can claim a combined exclusion of $375,000.
Observation. Because the reduced exclusion is calculated by multiplying the exclusion, rather than the gain, by the appropriate fraction, CPAs will find the reduced exclusion provision allows most gains to be fully excluded from income.
Gain from an involuntary conversion (such as destruction, theft, seizure, requisition or condemnation) of a home qualifies for the gain exclusion. In applying the rules of IRC section 1033 (involuntary conversions), the amount realized is reduced by the gain excluded under section 121. If the taxpayer acquires a replacement home, the ownership and use period of the converted home carries over to the replacement home if that home’s basis is determined using the involuntary conversion rules of section 1033(b). Presumably, an involuntary conversion will represent an unforeseen circumstance that allows taxpayers to qualify for a reduced exclusion even if it occurs within two years of another disposition. However, the IRS takes the position that a taxpayer cannot claim an exclusion based on unforeseen circumstances until it issues final regulations or other guidance on the matter.
Example. On January 1, 1992, Victor acquires and begins to live in a home that costs $50,000. On January 1, 2002, a tornado destroys the home. Victor receives $350,000 from an insurance company and, therefore, has a realized gain of $300,000 ($350,000 insurance proceeds minus $50,000 cost basis). The destruction of the home qualifies for gain exclusion under both section 121 and section 1033. Victor then purchases a new home for $80,000. Because he can exclude up to $250,000 of gain under the section 121 rules, for purposes of section 1033, the amount realized is $100,000 ($350,000 insurance proceeds minus $250,000 section 121 exclusion) and the realized gain is $50,000 ($100,000 amount realized minus $50,000 original home’s cost basis). Since Victor has purchased a replacement home for $80,000, he recognizes a gain of $20,000 ($100,000 amount realized minus $80,000 replacement home cost). The remaining $30,000 ($50,000 realized gain minus $20,000 recognized gain) is deferred. The basis of the replacement home is $50,000 ($80,000 cost minus $30,000 deferred gain). Victor’s 10-year ownership and use period of the original home will carry over to the replacement home.
QUESTIONS YET UNANSWERED
The proposed regulations provide many useful examples and interpretations that clarify the rules permitting taxpayers to exclude from income the gain on the sale of their home. However, unanswered questions remain. In particular, the three situations (a change in place of employment, health problems and unforeseen circumstances) that allow taxpayers to qualify for the reduced exclusion are not defined. It is hoped the IRS will clarify these items in the final regulations. CPAs will want to review these home sale rules with their clients and suggest tax planning strategies to ensure they maximize gain exclusion.
|Home Sale Gain Exclusion Basics
||A taxpayer’s principal residence, as determined by physical occupancy. |
||Taxpayers who own and use a home as a principal residence for at least two years during the five years prior to disposition. |
|How much qualifies?
||A gain of up to $250,000 per taxpayer ($500,000 for married taxpayers filing jointly). |
|When does a gain qualify?
||Upon the sale, exchange or involuntary conversion of a principal residence (limited to once every two years). |
||The excluded gain is permanently excluded from income, with no basis adjustments to a replacement home. |