Your Residence - The Ultimate Tax Shelter?
Understanding the Rules of the Game
© 2013 by Michael C. Gray, CPA
Thanks to legislation enacted during 1997 and subsequent guidance issued by the IRS, the rules of the game have been dramatically changed relating to the sale of a principal residence. There are significant tax planning opportunities in new rules.
You might think it's strange that I'm referring to the pre-1997 rules for sale of a residence in a current explanation, but I still get questions from people who are confused because they remember the old rules or a friend is giving advice based on them.
Goodbye to these familiar old rules!
For example, previously we were concerned with replacing the residence with another residence with a purchase price equal to or exceeding the selling price of the former residence within a certain time frame. That rule has been repealed. No replacement residence is required. Each residence stands on its own.
Previously, "fixing up expenses" were a factor in determining the deferred gain with respect to a principal residence. Fixing up expenses are no longer part of the computation under the new rules.
Previously, taxpayers age 55 or over were eligible to exclude $125,000 of gain from the sale of a principal residence. Under the new rules, taxpayers age 55 or over are treated the same as other taxpayers.
The exclusion amounts.
Under the rules for the sale of a principal residence, an individual may exclude from income up to $250,000 ($500,000 on a joint return) of gain.
A taxpayer may elect to recognize the gain from the sale of their residence. A taxpayer could decide to do this if the gain was small and the election enabled the taxpayer to claim the exclusion for another residence within the two-year period with a bigger gain.
Frequency of sales limit – ownership and use tests
The exclusion applies to one sale or exchange every two years. The home is not required to be the principal residence at the time of purchase or sale, it only needs to meet the ownership and use tests.
Under the ownership test, the individual must have owned the residence as a principal residence for a total of at least two of the five years before the sale or exchange. Effective for sales and exchanges after October 22, 2004, the residence must have been held for more than five years after the date of acquisition if the property was acquired in a tax-deferred exchange. For example, this would apply if property acquired in a tax-deferred exchange was initially used as rental property and was later converted to a principal residence.
Under the use test, the individual must have occupied the residence as a principal residence for a total of at least two of the five years before the sale or exchange.
The ownership and use tests may be met at different times, provided both tests are met for the five-year period before the sale.
Reduction of "second residence" exclusion/Reduction of exclusion for "nonqualified use" after 2008
Under the rules effective before 2009, a great feature was the ability to convert a residence that was previously a second home, a vacation home or a rental home to a principal residence. Once the home was used more than two years as a principal residence, the exclusion for sale of a principal residence could be claimed for the entire gain up to the exclusion limit ($250,000 or $500,000).
As a revenue raising measure to offset other breaks for homeowners in financial distress, Congress changed this rule in the Housing Assistance Tax Act of 2008, enacted on July 30, 2008 and effective January 1, 2009.1
Under the new rule, gain from the sale of a principal residence allocated to a period of nonqualified use will not be eligible for the exclusion. The allocation will be made by making a ratio of the periods of nonqualified use divided by the total period of time the property was owned by the taxpayer.
A period of nonqualified use is a period during which the taxpayer did not use the residence as a principal residence.
Fortunately, under a transitional rule, nonqualified use before January 1, 2009 will be disregarded for this test.
There are other exceptions to the rule:
- A period of nonqualified use during the five-year period ending on the date the property is sold that is after the last date the property was used as a principal residence by the taxpayer is disregarded. This should give the taxpayer up to three years to sell the home after moving out without having the exclusion reduced.
- A period of up to 10 years during which the taxpayer or the taxpayer’s spouse is serving on "qualified official extended duty" as a member of the armed forces, as a Foreign Service officer, or as an employee of the intelligence community is disregarded. In order to qualify for the extended duty exception, the taxpayer must be stationed at least 50 miles from the taxpayer’s principal residence.
- Temporary absences for vacations, traveling on business, etc. won’t be considered non-personal use.
- Other periods of temporary absence of up to two years because of a change of employment, health conditions, or other unforeseen circumstances specified by the IRS will be disregarded.
Gain up to the amount of accumulated depreciation for the property remains taxable (at a 25% tax rate) and not eligible for the exclusion.
For example, Jane Taxpayer bought a house for $200,000 on January 1, 2000. She rented the home to tenants from January 1, 2000 to December 31, 2009, and claimed accumulated depreciation deductions of $50,000. On January 1, 2010, she moved into the home and used it as her principal residence until January 2, 2012. Jane sold the home on December 31, 2014 for $400,000.
Nonqualified use before 2009 is disregarded. There were 12 months of nonqualified use during 2009. Nonqualified use from January 2, 2012 to December 31, 2014 is disregarded because it was during the five-year period after moving out of the residence and before the sale. The total months the home was owned was 15 years X 12 = 180.
Assuming the current tax laws apply (which is unlikely) when the residence is sold, here are the results:
Nonqualified use months 12 Total months / 180 Nonqualified use ratio .0667
Sales Price $400,000 Cost $200,000 Accumulated depreciation -50,000 Adjusted tax basis -150,000
Total gain 250,000 Accumulated depreciation taxable at 25% 50,000 Other gain 200,000 Nonqualified use amount – not eligible for exclusion $200,000 X .0667 (taxable long-term capital gain) 13,340 Gain eligible for exclusion 186,660 Maximum exclusion -250,000 Remaining gain subject to tax $ 0
So $13,340 of the gain will be subject to tax.
Remember that many states don’t automatically conform to Federal income tax law changes. You will need to find out if your state has conformed to this new rule to determine the state tax consequences of the sale of a principal residence for which there was a period of non-qualifying use.
Ownership and use of prior residences
For principal residences not acquired in a tax-deferred exchange, taxpayers may include the periods of ownership and use of principal residences with respect to which gain was rolled over to the current residence under the old rules.
For example, in 1995 Jack sold a residence he bought in 1980. He replaced the residence under the old rules in 1996. In applying the tests for holding periods under the new law, Jack is considered as acquiring the replacement residence in 1980.
The Tax Court has ruled that when a home is demolished and rebuilt, the ownership and use attributes of the old home don’t carry over to the new home. The ownership and use clock starts again for the replacement home.
A taxpayer who becomes physically or mentally incapable of self-care is deemed to use a residence as a principal residence during the time which the individual owns the residence and resides in a licensed care facility. In order for this exception to apply, the taxpayer must have owned and used the residence as a principal residence for at least one year during the five years before the sale or exchange.
The ownership and use of a spouse or former spouse are attributed to a taxpayer to whom a residence is transferred incident to a divorce.
The ownership and use of a deceased spouse are attributed to the surviving spouse, provided the surviving spouse hasn't remarried at the time of the sale or exchange.
A sale by an unmarried surviving spouse that otherwise meets the ownership and use tests within two years after the death of the deceased spouse is eligible for the $500,000 exclusion.
Married persons filing a joint return will qualify for the $500,000 exclusion on a joint return, provided (1) either spouse meets the ownership test, (2) both spouses meet the use test, and (3) neither spouse is ineligible for exclusion because he or she made a sale or exchange of a residence within the last two years.
Married persons who don't qualify for the $500,000 exclusion may still use the $250,000 exclusion, or a prorated exclusion, if either spouse meets the ownership and use requirements.
When a surviving spouse sells a residence, he or she will generally only be eligible for the $250,000 exclusion on his or her tax return filed as a single person, head of household or surviving spouse, unless the surviving spouse meets the requirements explained above for "widowed taxpayers." Since there is usually a basis adjustment to the fair market value of the residence as of the date of death for the decedent's interest in the property (100% for community property or the separate property of the decedent), no tax benefit will be lost unless the residence is the separate property of the surviving spouse. (The status of community property after a death for same-sex married persons and registered domestic partners is uncertain.)
Marraiges of same sex couples are not recognized by the federal government. These taxpayers aren't eligible to file joint income tax returns. Each same-sex spouse may be eligible to claim the $250,000 for his or her share of the gain on their individual income tax return, filed as a single person or head of household.
Gain recognized for depreciation.
Gain up to the amount of depreciation allowable for the rental or business use of the property after May 6, 1997 will be taxable at a special maximum long-term capital gains rate of 25% and not eligible for exclusion.
Home acquired in an exchange.
In order to qualify for the exclusion for a home acquired in a Section 1031 tax-deferred exchange, the taxpayer must own the property for at least five years in addition to meeting the other requirements.
For principal residences except for residences acquired in a tax deferred exchange after October 22, 2004, if a taxpayer does not meet the ownership or residence requirements, a pro-rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. The amount of the available exclusion is equal to $250,000 ($500,000) multiplied by a fraction equal to the shorter of the number of months of (1) the total of periods during which the ownership and use requirements were met during the five-year period ending on the date of sale, or (2) the period after the date of the most recent sale or exchange to which the exclusion applied divided by 24 months.
For example, Jane had to sell her residence during 2008 because she had to move for a new job. She is a single person. She bought her residence on January 1, 2007 and sold it on January 1, 2008. Her available exclusion is $250,000 X 12 / 24 = $125,000. If Jane realized a gain for the sale of her residence of $100,000, the entire amount would be excluded from her taxable income.
The IRS has issued regulations that explain many alternative scenarios that are eligible for the exclusion prorate. They make it clear that taxpayers who want to upgrade their residence because of an improvement in their economic status do not qualify. Otherwise, the regulations are surprisingly liberal, including allowing taxpayers to prove they are eligible for a hardship exception because of their "facts and circumstances"!
Military and government service extension.
Individuals serving in the United States uniformed services, foreign service, intelligence community and Peace Corps may elect to suspend the five-year period for meeting the two-year ownership and use requirements. The suspension applies while the individual or individual’s spouse is serving on “qualified official extended duty”. The maximum extension is ten years.
Nonresident aliens who gave up their US citizenship for the principal purpose of avoiding tax are not eligible for the exclusion.
The destruction, theft, seizure, requisition or condemnation of property is treated as a sale or exchange of the residence. Any gain in excess of the exclusion amount may be deferred by purchasing a replacement residence under the involuntary conversion rules.
Losses are generally not deductible
Since a loss from the sale of a principal residence is from the sale of a personal asset, it is not tax deductible.
Now seniors in high tax states, like California, can get a significant exclusion of gain from the sale of their principal residences and can exclude retirement benefits from their previous state’s tax when they move out of state. These are significant incentives to move to a state with no income tax, such as Washington or Nevada.
It will still be important to keep records of the improvements to your residence and your original escrow when it is likely you will sell the home for an amount over the exclusion amount and for state tax reporting.
For those who would have a substantial taxable gain under the new rules, it may make sense to convert the residence to rental property to be eligible for a tax-deferred exchange.
Remember that a residence that is inherited receives a new "tax basis" (cost to determine gain or loss) equal to the fair market value of the residence as of the date of death of the decedent or the alternate valuation date, if applicable. A residence that is held as community property by traditionally married persons is eligible to have the entire basis adjusted. (The status of same-sex married persons and registered domestic partners is uncertain.) However, this step-up in basis will be severely reduced if the estate tax is repealed. See your tax advisor.
Remember also that the tax basis of a residence that was a replacement residence for a pre-May 7, 1997 sale is reduced for any deferred gain from the previous sale.
An estate or trust does not qualify for the exclusion for the sale of a principal residence. As explained above, there should be little gain provided the sale takes place shortly after death. (There is a special exception to this rule under Internal Revenue Code Section 121(d)(11) allowing the exemption for an estate, formerly revocable trust or beneficiary when carryover basis was elected for a decedent who died during 2010. This was a very unusual election.)
The IRS issued rules that are surprisingly liberal for home offices. Although gain must be reported up to the amount of accumulated depreciation for a home office located within the main residence structure, it will otherwise qualify for the exclusion. A home office located in a separate structure from the main residence structure is not eligible for the exclusion. However, a separate structure home office may qualify for a tax-deferred exchange. See your tax advisor for details.
The new rules open up a whole new playing field for real estate investment on a tax-free (or minimal tax) basis.
- At retirement, a taxpayer could sell his or her principal residence, move to his or her vacation home, and sell the former vacation home after two years, qualifying for another exclusion of gain. (But see the new rules reducing this benefit after 2008, explained above.)
- An investor could move into "fix up" homes every two years. The rehabilitated homes could be sold every two years tax free (up to the exclusion amounts)!
- Suppose a taxpayer wants to retire to another location, and has a rental property in addition to a principal residence. The taxpayer could sell the principal residence and claim the exclusion amount. The rental property could be exchanged for another income property in the taxpayer's new location. The replacement rental property could be converted to a principal residence after it has been "aged" to insure the exchange. Then the former rental property could later be sold after the qualifying period of use as a principal residence (five years) and the exclusion claimed for the sale. (But see the new rules reducing this benefit after 2008, explained above.)
Your residence may well be "the ultimate tax shelter"! There are significant, legitimate opportunities to be exploited by aggressive taxpayers.
For more articles and information about new tax real estate tax developments, visit our Real Estate Investor Tax Articles or Frequently Asked Questions and subscribe to our newsletter, Michael Gray, CPA's Real Estate Tax Letter.
1 IRC § 121(b)(4) RETURN