Home Ownership: The American Dream
Home ownership is an integral component of the American Dream. But, in today’s society, individuals move from one home to another far more frequently than in our parents’ generation. Property values of homes have skyrocketed in many areas of the country, yet remain modest in other areas. As a result, prior tax code statutes pertaining to the recognition of gain on the sale of a principal residence were woefully outdated by the end of the twentieth century. Congress, in the interest of public policy, has generally encouraged home ownership by providing tax incentives. In May, 1997, the 1997 Taxpayers Relief Act, replaced old Sections 1034 and 121 of the Internal Revenue Code with a completely new § 121. The basic scheme of the new tax treatment can be summed up by I.R.C. § 121(a): “Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.” Most real estate attorneys and homeowners are familiar with the notion that a certain amount of gain (limited to $250,000 for individuals or $500,000 for couples) can be excluded from the sale of property that was the taxpayer’s principal residence two out of the last five years. The final IRS regulations pertaining to § 121 were issued in December 2002, more than five years after I.R.C. § 121 was enacted. This article will explore how the tax treatment for the sale of a principal residence has changed as a result of the 1997 Taxpayers Relief Act and the 2002 final regulations. Many taxpayer-friendly nuances provided in the tax code and in the IRS regulations may pleasantly surprise both the real estate practitioner and the homeowner.
In order to fully understand the current scheme, it would be helpful to review the old rules. The prior statutes, enacted in 1951, had two mechanisms to deal with gain from the sale of a principal residence: a rollover provision and a one-time exclusion available to older taxpayers. To defer gain recognition under old § 1034, the taxpayer had to reinvest his proceeds from the sale of a principal residence into a new principal residence of equal or greater value within 2 years. The taxpayer’s basis in the old property rolled over to the new property. The gain realized from the original sale, although not yet recognized, remained as built-in gain in the new home. The taxpayer could take advantage of this rollover provision every two years. Eventually, when the taxpayer cashed out on an ultimate sale, all the accumulated gain would finally be recognized. Taxpayers argued that this accumulated gain often merely represented inflation, and shouldn’t be taxed. To lessen the impact, old § 121 provided a $125,000 exclusion of gain recognition from the sale of principal residences for certain taxpayers. The election to exclude gain could only be taken once during their lifetime by taxpayers over the age of fifty-five who had used the residence as their principal residence three out of the preceding five years. In today’s more mobile environment, the prior provisions were simply too restrictive for many circumstances. The amount of the exclusion was often inadequate, and did not take into account that homeowners may move more than once after the age of fifty-five! Section 1034 was repealed in 1997, and an even more favorable exclusion of gain exists under the current § 121 than was afforded under old § 121.
Frequently Asked Questions
For the layman, many of the taxpayer-friendly provisions of § 121 might be easily overlooked. Most real estate practitioners make every effort to direct their clients to tax practitioners who can answer tax questions incident to the sale of a home. But, inevitably, questions will arise at closing. Some typical queries might be: I haven’t lived in my home for two years yet, but I have to sell it for health reasons, do I qualify for the exclusion? I am selling raw land adjoining my home; does that qualify for the exclusion? My husband held legal title to our home; can I also qualify for the exclusion? The following FAQ’s, although not exhaustive, may give some surprising answers:
2) How often can I exclude gain from the sale of eligible property? Only once every two years.[iii] But, if the taxpayer could qualify for the exclusion on more than one sale, he could choose which qualifying property affords the greater exemption. He could perhaps even file an amended return if the statute of limitations has not passed.[iv]
3) My husband and I lived in our home, but he was the only legal owner of the property. How much gain can we exclude? Married joint filers can claim a $500,000 exemption as long as one of them owned the residence, both of them used it for the qualifying period, and neither took another exemption during the preceding two years.[v]
5) I own and use more than one residence. Which one is my principal residence? If a taxpayer owns alternate residences, only one of them is his principal residence in a given tax year. Generally, the principal residence for each tax year is the property used during the majority of the year. A factual determination, however, must be made based on other relevant factors such as place of employment, abode of family members, address listed on tax returns, voter and vehicle registrations, mailing address for bills, location of banks, and the location of organizations in which taxpayer is affiliated.[vii]
6) I am selling my principal residence now, but I also sold 10 acres adjoining it last year. Can I combine the gain from both sales? Yes, if adjoining vacant land was also used as part of your principal residence during 2 out of the five years preceding its sale, and it sold within 2 years before or after the sale of the principal residence, you can combine the gain from both sales to reach a maximum combined exclusion of $250,000/$500,000.[viii]
7) I am selling my principal residence, but I also operate a business on my property. Can I still take the full exclusion? It depends on whether the non-residential portion of the property is separate from the dwelling unit or in the dwelling unit. For instance, a home office inside the dwelling unit would still be treated as one sale. But you could not exclude gain to the extent that you previously took depreciation – which must be recaptured.[ix] On the other hand, if you operated a business in another building on your property, you must allocate the relative values and relative gains, just like you did for depreciation purposes. You would bifurcate the transaction and treat it as two separate sales. You could take the § 121 exclusion on the residential portion of the sale. You might consider deferring taxes under § 1031 as to the business portion of the sale.
8) I only lived in my principal residence for one and a half years out of the last five years, but I had to move because my employer transferred me. Can I take the exclusion? Yes, you may be eligible for a prorated exclusion if you move because of a change in place of employment, health, or other unforeseen circumstances.[x] Some safeharbors apply that specify when the prorated exclusion is available. Even if a safeharbor isn’t available, other factors that might be relevant include a material change in the suitability of the residence as a principal residence, a material change in you financial ability to maintain the property, and the timing of the acquisition and use of the residence compared with the material changes.
9) What kinds of health reasons for a move would qualify for the prorated exclusion? Eligible reasons include facilitating the diagnosis and treatment of you, one of the other residents in the household, or even to care for certain relatives,[xi] or a physician’s recommendation.[xii]
10) What about other unforeseen circumstances that make a premature move necessary? There are special rules and safeharbors for other events that also enable the prorated exclusion, such as an involuntary conversion of the property, natural or man-made disasters, death or unemployment of one of the residents, a reduction in income, divorce, multiple births, etc.[xiii]
11) My mother owned her home for twenty years, but four years before she sold it she was admitted to a nursing home. Does she get a pro-rated exclusion? No. She can take the full exclusion. If she became physically or mentally incapable of selfcare, but owned the principal residence for two out of the five years, and used it for at least an aggregate of one year during that time, than the time she spent in a state-licensed nursing home or other facility will count towards her use requirement.[xiv]
12) A year ago, I moved into the home of my new husband. He had already lived there six years, but then he died shortly after I moved in. Do I prorate my use? No, your deceased spouse’s use is attributed to you, so you can claim the entire available exclusion.[xv]
13) After I moved out of my principal residence, I rented it to tenants for a year and took depreciation. Now I am selling it. Does my depreciation affect my gain exclusion? Yes, you can still take the exclusion, but not to the extent of prior depreciation.[xvi]
A thorough study and understanding of Section 121 of the tax code and the associated IRS regulations will help the real estate practitioner evaluate the issues that may face a homeowner at closing. A recognition that these provisions contain more than is commonly known should prompt the dirt lawyer to dig deeper!