Tax Planning for the Sale of a Principal Residence (Part II)

A variety of ownership situations may affect a taxpayers eligibility for a principal residence gain exclusion. Part II of this two-part article examines rules and planning for various ownership situations, and exclusions for more than one principal residence sale during a two-year period.

 

Steven Dilley, Ph.D., CPA
Professor of Accounting
Michigan State University
East Lansing, MI

For more information about this article, contact Dr. Dilley at dilleys@bus.msu.edu.
  

Executive Summary

• Final and temporary regulations elaborate on the two-year ownership requirement for the Sec. 121 gain exclusion.
• In many situations, another taxpayers ownership period is counted in meeting the principal-residence-ownership requirement.
• The new temporary regulations expand exceptions to the two-year ownership requirement when the primary reason for a second sale is a change of employment, health or unforeseen circumstances.

In December 2002, Treasury issued final regulations to clarify the principal residence gain exclusion under Sec. 121; this two-part article focuses on rules and planning opportunities stemming from the new rules. Part I, in the January 2004 issue, focused on how the property is used and the required periods of use. Part II, below, examines various ownership situations affecting a taxpayers eligibility for the exclusion. It also discusses gain exclusions for taxpayers who have to sell more than one principal residence during a two-year period.

How the Property Is Owned

Generally, a taxpayer must own the property for at least two years prior to sale to qualify for a Sec. 121 exclusion. However, there are many situations when another taxpayers ownership helps maximize the exclusion. Below is a list of ownership situations to consider in tax planning or when filing a return for a completed transaction:

• Same owner and user.

• One owner and more than one user.

• Multiple owners, but only one owner-user.

• Multiple owners and multiple owner-users.

• Special owners (e.g., trusts, limited liability companies (LLCs), bankruptcy estates, cooperatives and deceased or former spouses).

• Partial sales.

• Replacement property.

Same Owner and User

A single owner-user living in the residence is a very common situation that is usually uncomplicated.²²

One Owner and Multiple Users

The use of the property by anyone other than a spouse (or former spouse) of the taxpayer-owner does not count toward the latters use of the property. For example, in Regs. Sec. 1.121-1(c)(4), Example (2), the taxpayer-owner had not met the two-year use test when she ceased to use the property as her principal residence, but her son continued to live there. The sons use of the property did not count towards her use of the property.

An even more common illustration is a couple who lives together. Under Regs. Sec. 1.121-2(a)(3), a nonowner-spouses use of the other spouses property as the principal residence increases the gain exclusion to $500,000 if the couple files a joint return. However, if the nonowner is not a spouse, the use of the property by the nonowner significant other does not help the taxpayer-owners gain exclusion. Thus, the key question is: where is the nonowners principal residence? Is it the taxpayer-owners principal residence or some other residence? If it is some other residence, the nonowner may qualify for gain exclusion on that other residence.²³

Multiple Owners with One Owner-User

A residence may have multiple owners, but only one owner-user. Such situations can include either joint ownership or tenant-in-common ownership and may or may not involve married taxpayers.

Example 1: T and M, a married couple, work in different cities, T in Atlanta, GA, and M in New Orleans, LA. They own residences jointly in both cities. They sell the New Orleans house when M gets a job transfer to Atlanta. Their realized gain is $334,000.

T meets the ownership, but not the use, test for the New Orleans property and, thus, does not qualify for a gain exclusion. On their joint return for the year of sale, T and M should report a taxable gain of $84,000 ($334,000 $250,000), because they are entitled to exclude the sum of each spouses dollar limit amount, determined on a separate basis, as if they had not been married (zero for T, $250,000 for M).

Multiple Owners and Multiple Owner-Users

What if more than one person owns the property and they all meet the ownership and usage tests? Can they each receive up to a $250,000 exclusion or is there just one $250,000 ($500,000 on a joint return) exclusion for the property?  When there are multiple qualified owner-users, the $250,000 limit is per taxpayer, not per property.

Example 2: J, M and S are unrelated individuals. They purchase a house as tenants in common, live in it for at least two years and sell it for an $810,000 gain.

Each meets the ownership and use tests and each has a $250,000 excluded gain and a $20,000 included gain on their individual returns for the year of sale. Regs. Sec. 1.121-2(a)(1) states: A taxpayer is eligible for only one maximum exclusion per principal residence.²⁴ (Emphasis added.)

Special Owners

Ownership can sometimes be unusual. If a grantor trust or a single-member LLC (SMLLC) owns the property, the taxpayer is treated as though he or she owned the property directly under Regs. Sec. 1.121-1(c)(3)(i) and (ii). However, when the trust becomes irrevocable or the SMLLC member changes, the ownership attributable to the taxpayer ceases. According to Regs. Sec. 1.1398-3, a bankruptcy estate stands in the taxpayers shoes for purposes of the ownership and use tests; it succeeds to the Sec. 121 exclusion potential on commencement of the bankruptcy case.

When a cooperative housing corporation owns the property, the taxpayer is a tenant-stockholder in a corporation and does not own the real estate directly. Regs. Sec. 1.121-4(c) provides that the ownership requirement is applied to the stocks holding period. Also, a condominium owner owns an undivided interest in the condominium association common elements. That interest is sold with the condominium; the regulations do not indicate that the sale proceeds have to be allocated or that any portion of the gain derived from an increase in value of the common elements is subject to separate reporting.

Deceased spouse: Under Regs. Sec. 1.121-4(a), the ownership (and use) period for a deceased spouse tacks to that of the surviving spouse if the spouse is deceased at the sale date and the surviving spouse has not remarried. If the sale occurs in the spouses year of death, up to $500,000 of gain exclusion may be taken if a joint return is filed.²⁵ The rules are not as generous when property inherited from a spouse is sold in the year after the spouses death. The surviving spouse is now single and the gain exclusion may not exceed $250,000.²⁶ However, if the deceased spouse owned an interest in the property, the surviving spouse receives a basis step-up for one-half of the propertys value, so the gain on that portion of the property should be minimal if the sale occurs soon after the spouses death.

Divorce or separation: When a property is transferred in a Sec. 1041 transaction (i.e., divorce or legal separation), the former spouses ownership period tacks to the taxpayers under Regs. Sec. 1.121-4(b)(1). According to Regs. Sec. 1.121-4(b)(2), a taxpayer who continues to own the property after a divorce or legal separation also continues his or her use, as long as the former spouse continues to occupy the residence as his or her principal residence. This allows a former spouse to qualify for gain exclusion long after he or she stopped using the property as a principal residence.

Example 3: Six years ago, R and A were divorced. R transferred possession, but not his joint ownership interest in their home (home 1) to A, who continued to live there until their child graduated from high school. R remarried and has owned another home (home 2) since shortly after the divorce. A is not married. Home 1 was sold this year with a $560,000 realized gain.

R and A should divide the gain and each report a $30,000 taxable gain (($560,000 x 0.5) $250,000). If R and his second wife sell home 2 within two years of the sale of home 1, R will generally not be able to exclude his portion of the gain on home 2, but his current wife will be able to exclude her half of the gain, up to $250,000.

 Partial Sales

Generally, a taxpayer may exclude gain from the sale of a less-than-100% present interest in an otherwise qualified property. It does not seem to matter whether the purchaser is related to the seller. However, under Regs. Sec. 1.121-4(e), the gain exclusion per taxpayer is cumulative for that taxpayer and that property. Thus, the maximum $250,000 exclusion ($500,000 on certain joint returns) applies to the combined sales of partial interests by the same taxpayer. Special rules apply to the sale of a remainder interest and are discussed later in this article.

Example 4: On Jan. 10, 2003, A sells a 50% tenancy-in-common interest in his residence to his friend, C, for $305,000. As basis for the entire property was $320,000, so his gain realized on the portion sold is $145,000 ($320,000 x 0.5 5 $160,000; $305,000 $160,000 = $145,000). Assuming he meets the Sec. 121 requirements, he excludes the entire $145,000 gain and reduces his basis in the property to $160,000. In June 2005, A and C get married, sell the property and purchase another house jointly. The sale proceeds are $586,000. As realized gain is $133,000 ($586,000 x 0.5 = $293,000; $293,000 $160,000 = $133,000)..

A may exclude only $105,000 ($250,000 $145,000) from the 2005 sale and has taxable gain of $28,000 ($133,000 $105,000 = $28,000). C has a $12,000 nondeductible loss, because she sold her half for $293,000 and had a basis of $305,000. Cs loss may not be offset against As gain, even though they file jointly.²⁷

Regs. Sec. 1.121-4(e)(2) allows gain exclusion for a sale of a remainder interest, unless the purchaser is a related party as described in Sec. 267(b) (family members, controlled corporations, certain trusts and various other relationships) and Sec. 707(b) (controlled partnerships). If gain is excluded from the sale of a remainder interest, no other gain may be excluded from the sale of any other interest sold separately.

Replacement Property

There may be an interaction between the involuntary conversion (casualty, theft or condemnation) rules and the Sec. 121 rules. To the extent there is gain from an involuntary conversion, it is first excluded to the extent possible under Sec. 121. Under Sec. 1.121-4(d), the excluded gain reduces the involuntary conversion proceeds and, thus, the required reinvestment needed to postpone any remaining realized gain.

The ownership and use periods for the involuntarily converted residence are tacked on to that of the replacement property, even when gain has been excluded on the involuntarily converted residence.

Sales Within Two Years of Each Other

In many circumstances, taxpayers sell more than one principal residence within a two-year period. Generally, under Regs. Sec. 1.121-2(b), the taxpayer may choose to apply the exclusion rules to one sale (not both), even if both properties qualify as the taxpayers principal residence.²⁸

Example 5: H and S have owned and used as their principal residence a house in Michigan for 20 years. Their basis is $230,000 and the fair market value is $625,000, so there is a potential excludible gain of $395,000 on a sale. On Jan. 10, 2001, they jointly purchased a condominium in Hilton Head, SC, for $300,000, that is now worth $723,000. H and S sell their Michigan residence on May 14, 2004, and exclude the $395,000 gain on their 2004 return. On March 10, 2005, they sell their SC residence for a $423,000 gain. Assume that both residences qualify for exclusion under Sec. 121 at the time of their sale.

H and S would be eligible for only one gain exclusion. They could amend their 2004 return and report the Michigan home sale as taxable and then exclude the 2005 SC gain. However, substantial interest and penalties would be due with the amended 2004 return. It would be better to ensure that the SC residence is sold at least two years and a day after the sale of the Michigan residence (May 15, 2006); the gain from both sales would be excludible.²⁹

Exceptions to Two-Year Rule

What if a taxpayer sells his or her home, excludes the gain, buys another home, then has to sell that home within two years of the prior sale? Is an exclusion out of the question? NoSec. 121(c) allows a prorated portion of the maximum exclusion when the primary reason for the second sale is a change of employment, health or unforeseen circumstances. When the final regulations were issued, the IRS also issued temporary regulations³⁰ that dramatically expanded the proposed regulations explanation of how these special criteria may be met.

Under Regs. Sec. 1.121-3(g)(1), the maximum exclusion is prorated by multiplying it (either $250,000 or $500,000) by a fraction. The numerator of the fraction is the shortest of the following three time periods (expressed in days or months): (1) the ownership period for the early sale residence, (2) the use period for the early sale residence or (3) the time between the sale dates of the two residences. The denominator of the fraction is 730 days (24 months).

A two- or three-step approach is used under Temp. Regs. Sec. 1.121-3T(b). First, the taxpayer determines the reason for the early sale. If that reason appears to be a change of employment, health or unforeseen circumstances, then the regulations may provide a safe harbor, allowing an exclusion. If the safe-harbor requirements are not met, the taxpayer may use a list of six factors to determine if the primary reason for the move was a change of employment, health or unforeseen circumstances:

1. The sale or exchange and the circumstances giving rise to it are proximate in time.

2. The propertys suitability as the taxpayers principal residence materially changes.

3. The taxpayers financial ability to maintain the property materially changes.

4. The taxpayer uses the property as a residence during the period of his or her ownership.

5. The circumstances giving rise to the sale or exchange are not reasonably foreseeable when the taxpayer begins using the property as a principal residence.

6. The circumstances giving rise to the sale or exchange occur during the period of the taxpayers ownership and use of the property as a principal residence.

These factors are relevant, but may not all be important and may not be the only factors to consider.

Change-of-employment safe harbor: Under Temp. Regs. 1.121-3T(c), the change-of-employment safe harbor is met if the seller is a qualified individual and a distance test is met. The distance test is the same 50-mile test used in the moving expense rulesthe individuals new place of employment must be at least 50 miles farther from the sold residence than the former place of employment. Also, employment includes the commencement of employment with a new employer, the continuation of employment with the same employer and the commencement or continuation of self-employment.

A qualified individual includes the taxpayer, the taxpayers spouse, a co-owner of the residence and a person whose principal place of abode is the taxpayers residence. Thus, a qualified individual includes persons other than the taxpayer who may have been the cause of the move. For instance, two unmarried individuals, only one of whom has an ownership interest in the home, are living together. If the nonowner changes employment and the owner moves as a result, the sale of the residence is within the safe harbor.

Example 6: In January 2003, T moved from Chicago, IL, to St. Louis, MO, due to a change in employment. T sold her principal residence in Chicago on Dec. 5, 2002, and applied the $250,000 exclusion to the sale. T purchased a house in St. Louis on Jan. 17, 2003, moved in on Jan. 20, 2003 and lived there until Aug. 10, 2004, when she moved back to Chicago to start another new job. She sold the St. Louis home on Sept. 11, 2004, at a $23,000 gain.

T has moved because of a change in employment and is within the safe harbor; thus, all of her $23,000 gain is excludible. She owned the St. Louis residence for 603 days (Jan. 18, 2003Sept. 11, 2004), used it for 569 days (Jan. 20, 2003Aug. 10, 2004), and there were 646 days between the two sales (Dec. 5, 2002 and Sept. 11, 2004). Her maximum exclusion is $194,863 (569/730 x $250,000).

Health safe harbor: Temp. Regs. Sec. 1.121-3T(d) provides safe-harbor rules for a health-related move if the primary reason for the sale is to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury of a qualified individual or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness or injury. For purposes of the health safe harbor, a qualified individual also includes a potential dependent relative (including cousins). There is a presumption that the move is primarily for health if a physician recommends a change of residence for health reasons. However, a sale that is merely beneficial to the individuals general health or well-being is not for the primary reason of health, even if it is recommended by a physician.

Example 7: The facts are the same as in Example 6, except that T moves back to Chicago to live with her mother, who is no longer able to live independently. T quits her job in St. Louis and does not start work again in Chicago until her mother dies in 2006.

Ts $23,000 gain is still fully excludible, because her mother is a qualified individual. The re-duced maximum exclusion is again $194,863.³¹

Unforeseen circumstances safe harbor: Under Temp. Regs. Sec. 1.121-3T(e)s safe harbor for unforeseen circumstances, the primary reason for the early sale must be the occurrence of an event that the taxpayer does not anticipate before purchasing and occupying the early sale residence. In addition, one of the following specific events must occur:

• The involuntary conversion of the residence.

• Natural or man-made disasters or acts of war or terrorism resulting in casualty to the residence.

• A qualified individuals:

1. Death.

2. Cessation of employment for which the individual is eligible for unemployment compensation.

3. Change in employment or self-employment status that results in the taxpayers inability to pay housing costs and reasonable living expenses for his or her household.

4. Divorce or legal separation.

5. Multiple births.

• Other events listed in published IRS guidance.

As is apparent from this list, many circumstances qualify as unforeseen. However, the threshold criterion, that the taxpayer did not anticipate these circumstances before purchasing and occupying the residence, is somewhat limiting. For instance, what if the taxpayer buys a large home anticipating having children, but then there is an early sale because his wife is unexpectedly infertile and the home is too large for just the two of them? The sale is not within the unforeseen circumstances safe harbor, because it does not fit one of the specific events. However, it does seem to fit within some of the six general factors used to determine whether the primary reason for the early sale is a change of employment, health or unforeseen circumstances. The suitability of the property as the taxpayers residence has materially changed, the sale is proximate in time to the changed circumstances and the changed circumstances were not reasonably foreseen.

Conclusion

This two-part article provided a detailed look at the intricacies of the regulations on the sale of a principal residence. For many taxpayers, the appreciation in their residence(s) is one of their largest unrealized gains. Careful planning is often required to ensure that the gain from disposition of the residence is entirely excluded (or at least minimized). Because a transaction resulting in a fully excluded gain is usually not reported on a return, additional pressure exists to ensure proper tax reporting. The tax adviser must be very careful to document the reasons for the exclusion, in case the IRS later asks questions.