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

Final regulations on the principal residence exclusion clarify some issues under Sec. 121 and create new tax planning opportunities. Part I of this two-part article focuses on when and how the property is used.
 

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

• Eligibility for the principal residence exclusion depends on how the property is used and owned and the period of use and ownership.
• Significant planning is available for taxpayers who own multiple residences or multiple-use property.
• Allocation of sales proceeds is required when property is used for both residential and nonresidential purposes, but is not required for multiple uses of a residence.

On Dec. 23, 2002, the IRS issued final regulations on the exclusion of gain from the sale of a principal residence under Sec. 121.¹ The final regulations clarified several areas of concern in the proposed regulations and created several new tax planning opportunities to accompany the many existing under Sec. 121 and the proposed regulations. This two-part article emphasizes new opportunities created by the final regulations.

Part I, below, discusses the major rules and planning opportunities for required periods of ownership and use and how the property is used. Part II, in the February 2004 issue, will discuss how the property is owned.

Overview

Sec. 121 was enacted in the Taxpayer Relief Act of 1997 and is generally effective for sales or exchanges of a principal residence after May 6, 1997. A taxpayer may exclude $250,000 of gain ($500,000 on certain joint returns) from the sale if he or she owned and used the residence as his or her principal residence for two of the five years preceding the sale date. In general, the gain exclusion may not be taken again until two years after a sale resulting in an exclusion.

Example 1: T lived in a rental apartment in Chicago, IL, until she bought her first home for $165,000 on Aug. 15, 1999 (the closing and title transfer date). The home was in Evanston, a Chicago suburb. She lived in the home until June 10, 2003, when she moved to St. Louis, MO, due to a change in employment. T initially rented a home in St. Louis. She sold her Evanston home on Dec. 5, 2003, for $320,000 and bought a home in St. Louis on Jan. 17, 2004 for $255,000. T owned the Evanston residence for 1,573 days and used it as her principal residence for 1,395 days during the five-year period of Dec. 6, 1998Dec. 5, 2003.

Both the ownership and use numbers must be 730 days or more to exclude the gain, but do not have to be concurrent.² T has a $155,000 ($320,000 selling price $165,000 basis) excludible gain on the Evanston residence sale. Because the gain is entirely excludible, she does not have to report the sale on her 2003 return.³ T may use the proceeds from the Evanston sale for whatever she wishes; she does not have to reinvest them in another home.

While the sale of a taxpayers home is frequently not as simple as in Example 1, the Sec. 121 rules are extremely flexible and generous in allowing gain exclusion in many complex circumstances.⁴

Tax Planning Factors

The complexities in applying Sec. 121 and its regulations arise from a taxpayers living arrangements and how the rules treat those arrangements. Consequently, even more than usual, facts heavily drive the tax result. Generally, three categories of factors influence both planning and applying the law to a completed transaction:

1. Dates and time periods of ownership and use.

2. How the property is used.

3. How the property is owned.

Dates and Periods of Ownership and Use

The critical dates and time periods of ownership and use are: (1) when ownership began, (2) when use began, (3) when ownership ended, (4) when use ended, (5) the date three years after either ownership or use ended and (6) the length of use during a calendar year.

The Sec. 121 rules have a retroactive approachthey look back five years from the sale date. During that period, the taxpayer must have owned the property at least two years and used it as the principal residence for two years. However, for planning purposes it is better to take a prospective approach; once the residence has been owned and used as a principal residence for two years, it is an eligible principal residence for the five-year period. Consequently, the period in which the residence began to be owned and used as a principal residence is crucial.

Usually, the date ownership began can be easily determined, but when residence began is much more difficult. In Example 1 above, the closing documents determine when T began to own the Evanston house, but when did T move out of her apartment and begin living in the house? What if she did not move in immediately because she was remodeling? What if her apartment lease ran for another three months after she purchased the house? Regs. Sec. 1.121-1(b) uses a facts-and-circumstances test to determine a taxpayers principal residence; Regs. Sec. 1.121-1(b)(2)(i)(vi) lists the following relevant objective factors for the use test:⁵

• The taxpayers place of employment (not relevant to Ts apartment vs. Evanston house determination);

• The principal place of abode of the taxpayers family members (not relevant, because T is single and has no family members living with her);

• The address listed on the taxpayers Federal and state tax returns (did not change for T until she filed her 1998 returns in 1999), drivers license and automobile registration (the date of this change is not reflected on Ts drivers license or automobile registration, but may be on a receipt from the department of motor vehicles) and voter registration card (this typically has no record of when the registration was changed);

• The taxpayers mailing address for bills and correspondence (this information is filed with the U.S. Postal Service and others, but the date of the address change is unlikely to be recorded anywhere);

• The location of the taxpayers banks (Ts bank had branches throughout the Chicago area and she did most of her physical banking in the branch near her work); and

• The location of the taxpayers religious organizations and recreational clubs (T continued to attend the same church and her health club was located near her work location).

As illustrated above, the information required is often outside the taxpayers (and his or hers tax advisers) ability to prove. However, in IRS Pub. 523, Selling Your Home, the IRS has suggested a useful approach. The taxpayer should file Form 8822, Change of Address, to notify the IRS of a change in mailing address. Part I is used to change a personal address. The tax adviser should ensure that the taxpayer files this form as soon as he or she has changed residence and keeps a copy. The form is filed with the IRS Service Center for the former residence.

In addition to the facts listed in the regulations, many other facts could help verify a change of residence. For instance, a moving company receipt indicates when the taxpayer made a physical move to the property. Keeping a copy of the first bill or correspondence (e.g., a telephone bill) showing the changed address could be helpful. A copy of a payroll check stub with the changed address is additional objective evidence of a change of address. Because a facts-and-circumstances test is used to establish the date when the taxpayer began to use the property as a residence, the taxpayer should attempt to accumulate as much evidence as possible to support his or her position.

Determining when a taxpayer has stopped owning a residence is not difficult, because of the sale date. The use period usually also stops with the sale date, but may continue after a sale. The sale documents list the taxpayer-sellers move out date and rent is charged if the seller continues to occupy the property.

Multiple-Residence Planning

What if the taxpayer ceases to use the property as his or her principal residence, but continues to own and use it? This is the most common planning opportunity for taxpayers with multiple residences.

Example 2: 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. The couple did not change any of the objective factors related to their Michigan home when they purchased the Hilton Head property. All the Regs. Sec. 1.121-1(b)(2)(i)(vi) factors continue to indicate the Michigan home is their principal residence. However, they would like to sell the Hilton Head condominium and reinvest all the proceeds in a condominium in Naples, FL.

Two approaches might help H and S. First, they could change the factors that indicate that Michigan is their principal residence. Once they have done that, they could file Form 8822 to give the IRS official notice of the change of residence. They will have to wait at least two years from their change-of-address date until they can sell the Hilton Head property.

Majority-of-the-year-test: H and S could use the majority-of-the-tax-year test of Regs. Sec. 1.121-1(b)(2), which states: If a taxpayer alternates between 2 properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayers principal residence. This test appears to create an opportunity, but presents several practical problems.

If H and S both used the Hilton Head condominium for more than six months during 2001 and 2002, it would appear to be their principal residence. In Regs. Sec. 1.121-1(b)(4), Example (1), the taxpayer lived in Florida for five months of each calendar year and in New York for seven months of each calendar year, over a five-calendar year period. The Example concludes that New York is the taxpayers principal residence In the absence of facts and circumstances indicating otherwise.⁶ Thus, H and S would not be qualified to use the majority-of-the-year test to exclude the gain from the sale of the Hilton Head property until the objective factors are more beneficial.

A recent district court decision, Guinan,⁷ is the first case interpreting the majority-of-the-time test. Overall, the taxpayers spent the majority of the time at their Wisconsin home during the five-year-period before they sold it. However, in no single year during that period did they spend more time in Wisconsin than they spent in their other homes. Also, the couples voting and drivers licenses were not from Wisconsin. The court denied the home-sale exclusion on the sale of the Wisconsin home.

The three-year window: On the date H and S (in Example 2 above) establish the Hilton Head property as their current principal residence, the Michigan home continues to be a Sec. 121 qualified principal residence; it could be sold and the gain excluded for three years after it is no longer their current principal residence. Thus, taxpayers who have more than one home and change the one that qualifies as their current principal residence should carefully document how much time they have to sell the former principal residence. Once that three-year window closes, sale of the former principal residence no longer qualifies for gain exclusion.

The effect of absences: The regulations provide that, during any single calendar year, the taxpayer may have only one current principal residence and accumulate time for the use test for only that residence.⁸ Generally, the taxpayers physical occupancy of the residence is required.⁹ However, short temporary absences (such as for vacation) or other seasonal absences (although accompanied with rental of the residence), are counted as periods of use under Regs. Sec. 1.121-1(c)(2)(i). Neither the Code nor the regulations defines seasonal absence. However, Regs. Sec. 1.121-1(c)(4), Example (4), indicates that a college professors one-year sabbatical is not a short temporary absence; Example (5) indicates that a two-month summer vacation is a short temporary absence.

Absences can be very significant when a taxpayer does not have sufficient use to qualify for the exclusion, even though the home has been owned a sufficient amount of time. The regulations handling of absences is very vague and results in substantial uncertainty. For instance, for H and S of Example 2, how should the days in transit between Michigan and Hilton Head be counted? What if they were living in Hilton Head (meaning the block of time they usually spend there), but went home for a month or two to attend to family matters? How is use affected if they went on vacation for several weeks and, thus, were not at either residence?

Special one-year ownership and use rule: When a taxpayer moves out of a residence to any healthcare facility (including a nursing home) licensed by a state or political subdivision because he or she has become physically or mentally incapable of self-care, the two-year ownership and use requirement is reduced to a one-year ownership and use requirement. In addition, time spent in the facility counts toward the use portion of the test.

How the Property Is Used

In most circumstances, a principal residence consists of a house and land and the house is used only for personal activity; once the taxpayer has lived there two years and owned the property for two years, the home qualifies for the Sec. 121 exclusion. However, property use is often much more complicatedthere are issues related to the multiple uses of the house and use of the land.

Multiple uses of the dwelling unit: Regs. Sec. 1.121-1(e)(2) applies to multiple-use dwelling units. No allocation of the sale proceeds and the propertys adjusted basis is required if there is only one dwelling unit¹⁰ on the property at the time of the sale and the taxpayer meets the Sec. 121 ownership and use requirements for the entire property. This rule applies in two general situations.

First, the taxpayer may use a portion of a dwelling unit as a home office or for a business. If the taxpayer was not entitled to deduct any depreciation on the dwelling unit after May 6, 1997, the entire gain on the sale of the dwelling unit may be excluded under Regs. Sec. 1.121-1(e)(4), Example 6. Although the regulations do not deal with this, if depreciation was allowed or allowable for use after May 6, 1997, the sale must be reported on Form 4797, Sale of Business Property; the entire gain must be reported and the excludible gain must be shown as a loss. As illustrated in Regs. Sec. 1.121-1(e)(4), Example 5, the net gain is subject to the Sec. 1231 rules and is treated as unrecaptured Sec. 1250 gain if it carries to Schedule D.¹¹

The second situation involves a dwelling unit that was rental property, but qualifies for Sec. 121 gain exclusion at the time of sale. As shown in Regs. Sec. 1.121-1(d)(2), this may be property that was once rental property, but meets the Sec. 121 requirements at the time of its sale. Alternatively, it could be a property within which a separate dwelling unit existed, but was converted into a single dwelling unit prior to sale (e.g., a three-story home subdivided into two dwelling units and later re-converted into one dwelling unit).¹² If no depreciation was allowed or allowable (or no depreciation was allowed or allowable for use after May 6, 1997), the entire gain on the property sale may be excluded. If depreciation was allowed or allowable for use after May 6, 1997, the sale must be reported on Form 4797, the entire gain must be reported, the excludible gain must be shown as a loss, and the net gain is subject to Sec. 1231 (and is unrecaptured Sec. 1250 gain if it carries to Schedule D).

Interaction with the passive activity rules: In most cases in which property has been rented, the property was subject to the Sec. 469 passive activity rules. Thus, any recognized Sec. 1231 gain is passive activity gain. However, gain excluded by Sec. 121 does not offset passive activity losses (PALs). The Sec. 121 regulations are silent on the interaction between the Sec. 121 and 469 rules.

The instructions for Form 8582, Passive Activity Loss Limitations, under Dispositions of an Entire Interest, state: If you disposed of your entire interest in a passive activity or a former passive activity to an unrelated person in a fully taxable transaction during the tax year, your losses allocable to the activity for the year are not limited by the PAL rules. A fully taxable transaction is a transaction in which you recognize all realized gain or loss.¹³ Thus, it appears that a taxpayer with carryforward PALs from the property disposed of can only use those losses to the extent gain is recognized due to depreciation allowed or allowable after May 6, 1997.¹⁴ Thus, it appears that the loss carryforwards are unusable to the extent Sec. 121 excludes realized gain.

Multiple-use property: Allocation of sale proceeds and the propertys adjusted basis is required when the property was used for both residential and nonresidential purposes.¹⁵ Thus, if a portion of the property was used for residential purposes and a portion (separate from the dwelling unit) was used for nonresidential purposes, only the gain from the residential portion is potentially excludible under Sec. 121.

Some common situations when allocation is required include a property that (1) has both a residential dwelling unit and business assets (e.g., farmland that also contains the taxpayers home) and (2) includes vacant land and a residential dwelling unit. In the first situation, the sale of the property is treated as a sale of separate properties. The residential-portion gain may be excluded under the Sec. 121 rules. The nonresidential portion is a sale subject to Sec. 1231 and reportable on Form 4797.

Under Regs. Sec. 1.121-1(e)(3), the allocation of the proceeds is accomplished using the percentage of business use of the property reported on prior returns.¹⁶ If the nonresidential portion of the property was subject to the Sec. 469 passive activity rules, the carryforward losses will be fully usable. Thus, whether a sale of a multiple-use dwelling unit or a multiple-use property has occurred is an important determination.

When a property includes vacant land, the key question is: how much of the vacant land was used in connection with the residential dwelling unit? Case law under repealed Sec. 1034 and prior Sec. 121 included situations when the principal residence constituted the home plus 65 acres in Bennett,¹⁷ the home plus 13 acres in Bogley¹⁸ and the home plus 43.5 acres in Schlicher.¹⁹ Schlicher held that residential purposes could include land used for appreciating nature, living in open spaces, hiking, horseback riding, and enjoying unobstructed views of the countryside.

Under the final Sec. 121 regulations, not only is vacant land potentially part of the principal residence, but it can even be sold in a transaction separate from the sale of the principal residence and still qualify for gain exclusion. According to Regs. Sec. 1.121-1(b)(3)(i), vacant land is not part of the principal residence, unless: (1) it is adjacent to the principal residence dwelling unit, (2) the vacant land was owned and used as part of the taxpayers principal residence and (3) the principal residence dwelling is sold within two years before or after the sale of the vacant land. Each of these requirements presents both planning opportunities and dilemmas. Does adjacent mean contiguous, or something broader? For instance, does land across the road from the residence qualify if the taxpayer purchased it to protect the view? Many of the prior cases (including Schlicher) distinguished business or investment use of the land from residential use. Requirement (2) above incorporates this criterion into the regulations. The third requirement creates both an opportunity and a limit.

Example 3: O, a single taxpayer, purchases 50 acres of land in Montana on Jan. 23, 2001, for $677,000. There is a house (which he occupies), barns and fenced fields on the property. O does not run business activity on the property, but does ride horses on it for personal use. On Jan. 30, 2003, O sells 27 acres of the property to a real estate developer. He determines the basis for the acres sold by obtaining a real estate appraisal on the house, the 27 acres sold and the 23 acres he still owns. O reports a $112,000 gain on the sale of the 27 acres on his 2003 Form 1040 Schedule D. Because of noise and construction on the property sold, O can no longer enjoy the remainder of his property, so he sells it on Sept. 20, 2004 at a $178,000 gain.

O may exclude the gain from the land sale, but only to the extent that the gain does not exceed $250,000 of gain from disposition of the entire property. Thus, when O files his 2004 return, he would not report the $178,000 gain, because it qualifies for the Sec. 121 exclusion. He may also file an amended 2003 return and exclude $72,000 of gain ($250,000 total gain exclusion $178,000 2004 gain exclusion).²⁰

If O sold the residential dwelling unit portion of the property at a loss, he could net that loss (say a $45,000 loss) against the gain from the vacant land sale. He would file an amended 2003 return and exclude the entire $112,000 gain (because $112,000 gain $45,000 loss nets to less than $250,000).²¹

Conclusion

Part I above discussed two of the three tax planning categories for the principal residence exclusion: (1) the dates and time periods related to ownership and use and (2) how the property is used. Part II, in the February 2004 issue, will discuss rules and planning based on how the property is owned.