Tax issues

Gain exclusion and deferral issues for homes.

From The Tax Adviser:

The Sale of a Principal Residence

T he largest asset owned by the average American taxpayer (single or married) is his or her personal residence. The tax laws governing the purchase and sale of personal residences have taken on new significance—and their application has become more complex—as the frequency of marriage, divorce and remarriage accelerates.

The Internal Revenue Code does not specifically define principal residence. Generally, it is the residence a taxpayer occupies the majority of the time, and it need not be located in the United States. While a taxpayer may have several personal residences, only one can be the principal one.

Two major tax breaks are available for a taxpayer who sells a principal residence.

Deferral of gain. Under Internal Revenue Code section 1034, a taxpayer may defer all or a portion of any gain realized on the sale of a principal residence if the taxpayer purchases or builds a new principal residence within two years before or two years after the sale of the old residence. For this purpose, a sale includes cash transactions, exchanges and replacements due to condemnation or other involuntary conversion.

The deferral of gain is available only if the cost of purchasing the new residence exceeds the adjusted sales price of the old residence. Thus, the costs attributable to the acquisition, construction, reconstruction and capital improvements of the new residence, as well as fixing-up and selling expenses of the old residence, must be factored into this calculation.

Permanent exclusion. Under section 121, certain taxpayers can elect to exclude up to $125,000 of the gain on the sale or exchange of a principal residence.

To be eligible, a taxpayer must be at least 55 years old before the date the residence is sold and must have owned and used the home as his or her principal residence for at least three years during the five years prior to sale.

If a married couple filing jointly owns the residence as joint tenants or tenants by the entirety or as community property, the exclusion is available as long as one of the spouses meets both the age and use requirements; it is not available if one spouse meets the age requirement and the other the use requirement. In addition, both spouses must consent to the election.

Once a taxpayer has elected this exclusion (even if not for the maximum amount), it is never again available to that taxpayer or to his or her spouse (or any future spouse).

Combining deferral and exclusion. If a taxpayer meets all the applicable requirements, he or she can use both these provisions.

If a couples residence is transferred to one spouse as part of a divorce, in general no gain or loss is recognized.

If the couple sells the residence and divides the proceeds, each spouse may defer the gain by buying a new principal residence. If the couple sells the home and elects to exclude the gain while still married, the $125,000 exclusion limit will be split equally; however, if they wait to sell until legally separated or divorced, each can take the full exclusion (since marital status is determined at the time of the election).

If one of the spouses continues to live in a marital home still owned by both spouses, the resident spouse continues to be eligible to defer or exclude gain on its sale or exchange (assuming all the applicable requirements are still met). Note that if the home is not sold within two years of the time the nonresident spouse vacates it, the nonresident spouse no longer will be eligible for deferral or exclusion of gain on its sale, as the home no longer will qualify as his or her principal residence.

When one or both individuals who decide to marry already own principal residences, they need to consider the effects the gain deferral and/or exclusion rules will have on the sale of one or both of these residences. To take maximum advantage of such opportunities, it may be necessary to take some actions before getting married.

For a detailed discussion of these issues, see "Maximizing Gain Exclusion/Deferral When Selling a Principal Residence Due to Death, Divorce or Marriage," by Hilari Pickett, Robert Gardner and G. Fred Streuling, in the February 1997 issue of The Tax Adviser.

— Nicholas Fiore, editor The Tax Adviser

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