Home Sale Regulations
The IRS recently proposed regulations on the home-sale gain exclusion enacted in the 1997 Tax Relief Act [Prop. Reg. Sec. 121.1 through 121.4]. The exclusion exempts from tax up to $250,000 ($500,000 for joint filers) of the gain from the sale of a home if the taxpayer owned and used the home as a principal residence for at least two years during the five-year period prior to the sale and has not used the exclusion within the prior two years. A taxpayer who fails to meet these requirements for specified reasons may be entitled to reduce exclusion.
The new regulations deal mainly with four areas:
- The definition of a principal residence
- The business use of a home and how it affects the exclusion
- The exclusion requirements for joint filers
- Availability of the reduced exclusion of certain taxpayers
In most situations you won’t have too much of a problem determining whether a home a client sells is his or her principal residence. But the new regulations say that when a client alternates between two homes, the home that is used for a majority of the time during the year will ordinarily be considered the principal residence.
As with the old exclusion for over aged 55 home-sellers, the new exclusion is available for houseboats, home trailers, and co-op apartments, as long as they are the owner’s principal residence.
Ownership and use requirements- the two-year requirement for use and ownership does not have to be a consecutive period of time. The regulations permit a client to claim the exclusion if he or she can show that the home was owned and used as a principal residence for 24 full months or 730 days during the five year period ending on the date of sale.
For purposes of the two-year use requirement, there must be actual occupancy of the residence.
However, short temporary absences (e.g. vacations) will be counted as a period of use even if a client rents out the residence during his or her absence.
Example 1– Bob Blake has owned and used his house as his principal residence in 1986. On January 1, 1998 he moved to another state and rented the house. On April 18, 2000 Blake qualifies for the exclusion because he owned and used the home for at least 2 out of the 5 years preceding the sale.
Example 2– Barbara Quinn owned and used a house as her principal residence from 1986 to the end of March 1997 when she moved out. In March 1999 Quinn’s son moved into the house and used it until it was eventually sold on July 1, 2001. Quinn does not qualify for the exclusion because she did not meet the two-out-of –five year use requirement.
Example 3– Marcia Livingston lived in a townhouse that she rented from 1993 through 1997. On January 1, 1998, she purchased the townhouse. On February 1, 1998, Livingston moved into her daughter’s home and rented out the townhouse. On March 1, 2000, she sells the townhouse. Livingston qualifies for the exclusion even though she only owned and lived in the house concurrently for a one-month period. In the five years prior to the sale, she lived in the townhouse for 35 months and owned it for 26 months.
Example 4– Virginia Nelson purchased a house on February 1, 1998; She used the house as her principal residence until she sold it 25 months later, on March 1, 2000. During 1998 & 1999, Nelson left the home each year for a two-month vacation. So she was physically present in the home for 21 months prior to the sale. Nevertheless, the IRS says that Nelson will qualify for the exclusion because the vacations were short, temporary absences and are counted as part of her occupancy of the house.
Example 5– Thomas Lake, a college professor, purchased and moved into a house on May 1, 1997. He used the house as his principal residence until September 1, 1998, when he went abroad for one-year sabbatical leave. He returned to the house on September 1, 1999, and sold it on October 1, 1999. The IRS says that Lake does not qualify for the exclusion because his sabbatical was not a “short, temporary absence.” Without the sabbatical, Lake does not meet the two-year use requirement.
What’s Short? The new regulations do not say. However, in other areas of taxes, such as the definition of a tax home for travel expense purposes, and in recent IRS pronouncements on the deductibility of commuting expenses to temporary work locations, one year is the dividing line. So, perhaps, if Lake had returned to his home before September 1, he might have qualified for the exclusion.
Business Use Of A Home If a client uses a portion of a residence for business purposes, then the residence is treated as two properties for purposes of the two-out-of-five-year ownership requirement, and each will have to qualify to claim an exemption on the entire gain from the sale. For example, suppose a client owned a home for three years prior to the sale. The client used a portion of the home as a principal residence for the entire three years. But the other portion was used as a home office for two of the three years. In this situation, the client can claim the exclusion only on that part of the sale gain not allocable to the office portion of the residence. The gain allocable to the office portion may be treated as “unrecaptured Section 1250 gain ” (taxed at a 25% capital gain tax rate) to the extent of prior depreciation. On the other hand, if the office portion was used as an office for only one year during the three-year period was used two years for residential purposes, then the client meets the two-out-of-five-years test on the whole residence. However, the entire gain still will not qualify for the exclusion because of a…..
Special Rule: If a client has client claimed depreciation on the home for example, the home was rented out for a period of time- then a portion of the gain may not qualify for the exclusion even if the two-out-of-five-year requirements are met. The exclusion is not available to the extent of depreciation attributable to periods after May 6, 1997. Instead, it’s treated as unrecaptured Section 1250 gain.
In a situation where a portion of the gain is already ineligible for the exclusion (e.g., the home office situation above), then this special rule applies to the extent the depreciation claimed exceeds the already ineligible gain.
Example 6– On July 1, 1999, Frank Parker moves into a house that he owns and had rented to tenants since July 1, 1997. Parker took depreciation deductions totaling $14,000 for the period that he rented the property. After using the residence as his principal residence for two full years, Parker sells the property on August 1, 2001, at a $40,000 gain. Only $26,000 may be excluded. The other $14,000 of gain is unrecaptured Section 1250 gain.
Example 7– Jennifer Grayson buys a house in 1998. For 5 years, she uses a portion of the property as her principal residence and a portion of the property for business purposes. Grayson claims depreciation deductions of $20,000 for the business use of the property. She sells the property in 2003, realizing a gain of $50,000, $15,000 of which is allocable to the business-use portion of the property.
The $15,000 allocable to the business-use portion of the property is not eligible for the exclusion. She must report it as unrecaptured Section 1250 gain. In addition, the exclusion does not apply to the extent that’s Grayson’s post May 6, 1997, depreciation-$20,000- exceeds the gain allocable to the business use portion of the property $15,000.
It’s also unrecaptured Section 1250 gain. So only $30,000 of Grayson’s $50,000 gain is eligible for the exclusion.
Joint Filers: A couple filing a joint return may qualify for an exclusion of up to $500,000 if:
- Either spouse meets the two-year ownership test;
- Both spouses meet the two-year use test; and
- Neither spouse has claimed the exclusion within the prior two years.
If a couple does not qualify for the $500,000 exclusion, then each spouses exclusion will be figured as if they were not married. However, for this purpose, each spouse will be treated as owning the property for the period the other spouse owned it.
Example 8– Joe and Claire Benson sell their residence and file a joint return for the year of the sale. Claire, but not Joe, meets the two-out-of-five-year use requirement. They are eligible to exclude up to $250,000 of the gain from the sale of the residence because that is the sum of each spouse’s dollar limitation computed separately ($0 for Joe, $250,000 for Claire).
Example 9– During 2000, Ted and Mary Smith got married. They each sell a residence that each had separately owned and used as a principal residence before their marriage. Ted and Mary met the ownership and use tests for their respective residences, but neither meets the use requirement for the others residence.
Ted and Mary file a joint return for 2000. The gain realized from the sale of Ted’s residence is $200,000, while Mary’s residence yields a $300,000 gain. Ted and Mary are each eligible to exclude up to $250,000 of gain from the sale of their residences. However, Ted may not use his unused exclusion to exclude gain in excess of Mary’s exclusion amount. Therefore, the Smith’s must recognize $50,000 of the gain realized on the sale of Mary’s residence.
Reduced Exclusion: For some of your clients, the exclusion is not an all or nothing deal. They may get a partial exclusion even if they don’t meet the ownership or use test or have used the exclusion within the prior two years. The reduced exclusion is available when the sale of the home is necessitated by health, a change in the place of employment, or other “unforeseen circumstances.”
The reduced exclusion is computed by multiplying the $250,000 or $500,000 maximum exclusion by a fraction. The numerator, which may be expressed in days or months, is the shortest of the following periods:
- The time the taxpayer owned the property during the five years prior to the sale:
- The time the taxpayer used the property as a principal residence during the five years prior to the sale:
- The time between the date of a prior sale on which the taxpayer claimed the exclusion and the date of the current sale:
The denominator of the fraction is 730 days or 24 months, depending on how the numerator is expressed.
Example: On January 15,1999, Bill and Kay Thompson were married. They moved into a home that Bill has owned and used as a principal residence since 1996. On January 15, 2000, Bill sells the house because of a change in his and Kay’s place of employment. Neither Bill nor Kay utilized the exclusion in the prior two years.
The Thompson’s are not eligible for the $500,000 joint exclusion because Kay has only used the home as her principal residence for one year. So their exclusions will have to be figured as if they were not married.
Bill can claim the full $250,000 individual exclusion because he meets the ownership and use test. Kay is entitled to a reduced exclusion because the sale of the house was due to a change in the place of employment. She multiplies the $250,000 exclusion by a fraction: 365 days/730 days. So she can claim an exclusion of $125,000- a total exclusion for the Thompson’s of $375,000.
Death & Divorce: The new home-sale exclusions regulations (see above) provide that the time period that a home is owned and used as a principal residence can sometimes be “tacked-on” to another period. For example, suppose one spouse dies and another spouse inherits the home. The regulations say that the survivor can include the decedents period of ownership and use in meeting the two-year requirement as long as the survivor has not remarried at the time of sale.
The regulations also allow a taxpayer who receive a home from his or her spouse under a divorce or separation agreement to count the transferring spouse’s period of ownership in determining whether the two-year requirement is met. And a taxpayer is treated as using a home as a principal residence if his or her spouse occupies it under a divorce or separation agreement.
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