In 2003, the IRS issued new liberalized rules interpreting the $250,000 principal residence sale tax exemption (up to $500,000 for a married couple filing jointly) and the first court case interpreting Internal Revenue Code 121 was decided. Before getting to the new developments, let’s review the basic rules.
THE EASY ELIGIBILITY RULES. Internal Revenue Code 121, enacted by Congress in 1997, offers up to $250,000 tax-free principal residence sale capital gains. A qualified married couple can claim up to $500,000 tax-free sales home profits.
Purchase Bob Bruss reports online.
To qualify, the seller(s) must have owned and occupied their principal residence an “aggregate” two of the five years before the home sale. Occupancy need not be continuous. Nor must the residence be the seller’s principal residence at the time of sale.
For example, if the seller owned and occupied the home for two years, and then rented it to tenants up to three years, the sale qualifies. This tax exemption can be used over and over again without limit. But it cannot be used more frequently than once every 24 months.
The method of holding title is not important. For a married couple, to claim up to $500,000 tax-free sale profits, only one spouse’s name need be on the principal residence title providing both spouses meet the occupancy test. Or, if title is held in a living trust, new IRS regulations clarify the full tax exemption is still available.
Gone are the old pre-1997 principal residence tax rules involving the need to buy a replacement home and the once in a lifetime “over 55” age restrictions.
TESTS FOR DETERMINING YOUR PRINCIPAL RESIDENCE. In 2003, the first U.S. District Court interpretation of Internal Revenue Code 121 was decided. Retirees James and Jean Guinan sold their part-time Wisconsin home. They met the two-out-of-five-year ownership and occupancy tests. In addition, they met some of the IRS principal residence regulation tests, such as Wisconsin automobile registration and bank accounts.
However, the court noted the Guinans lacked Wisconsin voter registration, local civic contacts, employment, and they never filed Wisconsin income tax returns. The court ruled the result was insufficient evidence to prove “relevant factors” so they owed $45,009 capital gain tax on the sale of the Wisconsin home (Guinan v. U.S., 2003-1 USTC 50475).
PARTIAL EXEMPTION AFTER LESS THAN TWO YEARS OWNERSHIP AND OCCUPANCY. Another new 2003 development for home sellers involved partial exemption rules if the principal residence is sold after less than 24 months of ownership and occupancy.
Last year the IRS issued new principal residence sale regulations that can be used retroactively for transactions, which are still “open” for income tax returns up to three years ago for tax years 2003, 2002, 2001 and 2000.
The IRS clarified a partial $250,000 exemption is available for home sales within less than 24 months of ownership and occupancy if the reason for the sale is (a) change of employment location, which qualifies for the moving cost tax deduction, (b) health reasons for illness treatment or to care for a family member, and (c) unforeseen circumstances.
Unforeseen circumstances are defined by the IRS to include death, divorce, unemployment, change of employment leaving the taxpayer unable to pay the mortgage or basic living expenses, multiple births from the same pregnancy, damage to the residence, condemnation, and involuntary conversion of the property.
Partial exemptions are now available for these situations based on the percentage of the 24-month occupancy time. For example, if you occupied your principal residence for 18 of the required 24 months, and sold due to one of the approved reasons, you will then be entitled to 75 percent of the $250,000 or $500,000 principal residence sale exemption.
SPECIAL RULE FOR DIVORCED AND SEPARATED COUPLES. Inter-spousal real estate transfers, during the marriage or as part of a divorce or legal separation, are tax-free by using Internal Revenue Code 1041.
However, if the couple retains co-ownership, but just one ex-spouse remains living in the principal residence while the other ex-spouse lives elsewhere, each spouse can claim up to $250,000 tax-free sales profits if the spouse living in the home meets the two out of five years occupancy test when the home is sold.
In other words, if the “in spouse” living in the principal residence qualifies for the IRC 121 $250,000 exemption, the “out spouse” not living in the residence also qualifies for up to $250,000 tax-free capital gains when the home is sold.
NEW RULE FOR SALE OF ADJOINING LAND. The 2003 IRS regulation changes now allow use of the principal residence exemption when adjoining vacant land is sold even if the home isn’t sold at the same time. The land sale can now qualify for the $250,000 or $500,000 exemption if the adjacent parcel is sold within 24 months before or after the principal residence sale.
THE SURVIVING SPOUSE RULE WASN’T CHANGED. However, the surviving spouse rule of Internal Revenue Code 121 wasn’t changed in 2003. Although this rule seems unfair, it really isn’t.
A surviving spouse can claim up to $500,000 principal residence sale tax-free profits if the home is sold in the year of the other spouse’s death. However, if the home is sold after the year of the spouse’s death, the exemption reverts to $250,000.
Contrary to popular myth, this rule doesn’t force surviving spouses to sell their homes promptly to claim the $500,000 tax exemption. The tax reason is the surviving spouse usually receives a new “stepped-up basis” for the home as of the date of the spouse’s death.
In most states, the stepped-up basis applies to the half of the home inherited from the deceased spouse. However, in the community property states of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin, the surviving spouse’s new basis is usually stepped-up to 100 percent of market value on the date of death. The tax result is little or no tax is due if the home is sold within a few years after the first spouse’s death.
PARTIAL INTEREST SALES QUALIFY FOR THE EXEMPTION. When a principal residence co-owner sells all or part of their interest in the home, that sale can qualify for the $250,000 exemption. However, if the co-owner sells less than their full interest in the home, this does not create a new loophole because the regulations allow only a total exemption up to $250,000.
HOW TO AVOID TAX ON THE SALE OF A VACATION SECOND HOME. When selling a vacation or second home, the Internal Revenue Code 121 tax break doesn’t apply because it is not the seller’s principal residence.
However, the best way to avoid tax on the sale of a vacation or second home is to convert it to a rental property and then make a Starker tax-deferred exchange using Internal Revenue Code 1031(a)(3) for another qualifying investment or business property.
The Starker exchange rules are (1) the sales proceeds from the rental or investment property must be held beyond the trader’s “constructive receipt” by a third-party intermediary (such as a bank trust department or title insurance exchange subsidiary), (2) the qualifying replacement property of equal or great value must be designated to the intermediary within 45 days after the sale, and (3) the acquisition must be completed within 180 days after the sale of the old exchanged property closes.
CONCLUSION. Principal residence and vacation home sellers can avoid federal capital gain tax by careful advance tax planning. Consultation with your personal tax adviser is suggested.
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