Income Tax from Gain or Loss from Sale of Residence

An individual may exclude from income up to $250K of gain ($500K on joint return, in most situations) realized on the sale or exchange of a principal residence [I.R.C. section 121(b), as amended May 6, 1997]. (U.S. Internal Revenue Service)

"Owners" and "use" tests must be met. 

The exclusion may not be used more than once every two years [IRC code section 121(b)(3)].

Ownership and Use. 

Gain may only be excluded if, during the five-year period that ends on the date of the sale or exchange, the individual owned and used the property as a principal residence for periods aggregating two years or more.  Short temporary absences for vacations or seasonal absences are counted as periods of use, even if the individual rents out the property during these periods of absence.  However, an absence of an entire year is not considered a short temporary absence.

The ownership and use tests may be met during non-concurrent time periods, provide that both tests are met during the five years period that ends on the date of sale [IRS regulation 1.121-1c].

Portion not used as principal residence.

An individual cannot claim the exclusion for any portion of the gain that is allocable to the portion of the property that is separate from the actual residence [i.e. the dwelling unit) and not used as a residence.

Note: If a person uses a portion of the residence for business, that portion is not eligible for the exclusion provision.  However, the gain allocable to the home and real property on which the business was operated qualifies for the exclusion.

The IRS has provided a number or examples that illustrate the allocation rules that are to be used in situations involving: (1) non-residential use of property not within the home, (2) rental of the entire property not within the home, (3) non-residential use of a separate home, (4) the conversion of a separate home into the person’s home, and (5) depreciation of a portion of the person’s home.

Married Individuals.  

The amount excludable as gain is $500K for individuals filing jointly if: (1) either spouse meets the ownership test, (2) both spouses meet the use test, (3) neither spouse is ineligible for exclusion by virtue of a sale or exchange of residence within the prior two years.

The exclusion is determined on an individual basis.  Thus, if a single person who is otherwise eligible for an exclusion marries someone who has used the exclusion within the two years prior to the sale, the newly married person is entitled to a maximum exclusion of $250K. Once both spouses satisfy the eligibility rules and two years have passed since the exclusion was allowed to either of them, they may exclude up to $500K of gain on their joint return (IRS reg. 1.121-2).

Deceased spouse. 

When a spouse dies before the date of sale, the surviving spouse is considered as owning and living in the home for the same period as the deceased spouse (IRS reg. 1.121.4a).

Divorced persons. 

When a residence is transferred to a person incident to a divorce, the time during which the person’s spouse or former spouse owned the residence is added to the individual’s period of ownership.  An individual who owns a residence is deemed to use it as a principal residence during the time the individual’s spouse or former spouse has use of the home under a divorce or separation agreement (IRC sec. 121(d)(3)].

Hardship relief.  

A person who fails to meet the ownership and use requirements, for the minimum two year time period for claiming the full exclusion (e.g., $250K, may still be eligible for a partial exclusion when the sale of the home is due to: (1) change in place of employment, (2) health reasons, or (3) unforeseen circumstances, section 121c2).  According to IRS, in order for person to be eligible for the partial exclusion, the person’s primary reason for sale must be related to one of these 3 reasons. If the person is able to satisfy the safe harbor test, then the primary reason for the sale will be deemed to have been due to  employment, health, or unforeseen circumstances.

September 11, 2001, Safe Harbor. 

Persons affected by the September 11, 2001, terrorist attacks may qualify for the reduced exclusion if certain requirements are met.

Other tests.

If the person is unable to satisfy one of the safe harbor tests, then the IRS will consider other factors in determining the principal reason for the sale.  These factors include such as giving rise to the sale and the person’s financial position. [IRS Temp Reg. 1.121-3Tb].

Incapacity.  

If an individual become physically or mentally incapable of self care, the person is deemed to use a residence as a principal residence during the time in which the person owns the residence and resides in a licensed care facility (e.g., a nursing home).

Reporting requirements of IRS for Gain on Sale of Residence.

An individual who is qualified to exclude all of the realized gain from sale of a home is not required to report the sale on the tax return for the year of sale.  However, if there is a portion of the realized gain that must be recognized, the taxpayer generally reports the entire gain.  Directly below the line on form 1040 where realized gain is reported, the amount of prorated exclusion is entered and identified as Section 121 exclusion. 

If the home was sold under the installment method and gain is recognized, form 6252 installment sale income has to be filed.  If the home was used for business or to produce rental income during the year of sale, form 1797 sale of business property is filed.

Gain Recognized to Extent of Depreciation.

The exclusion does not apply and gain is recognized to the extent of any depreciation claimed with respect to the rental or business use of a principal residence after May 6, 1997 [IRC 121(d)(6).

Remainder Interests.

The exclusion applies to gain on sale or exchange of remainder interest in principal residence, provided person acquiring residence is not member of taxpayer’s family or other related entity as defined by IRC sec. 267 or 707(b); IRC 121(d)(8).

Expatriates.

The exclusion is not available to non-resident alien individuals who are subject to IRC 877(a)(1) because they gave up their US citizenship for the principal purpose of tax avoidance [IRC 121(e)].

Involuntary Conversion. 

For purposes of determining allowable exclusion, the destruction, theft, seizure, requisition, or condemnation of property, is treated as a sale or exchange of the residence. In addition, the ownership and use of property acquired in involuntary conversion generally includes ownership and use of the property treated as sold or exchanged. For purposes of rules governing involuntary conversions [i.e. IRC 1033], the amount realized from sale or exchange of property is equal to amount of realized gain, reduced by amount of gain that is permitted to be excluded from income under the $250K/$500K exclusion [IRC 121(d)(5)].

Co-Ops.

The ownership of stock in cooperative housing corporation is the equivalent of ownership or residence if the seller, during the 5 year period ending on the date of sale, owned the stock for at least 2 years and lived in the house or apartment as principal residence for at least two years [IRC 121(d) (4)].

Important Terms. 

In order to determine gain or loss on sale of a home, the person must be able to determine:

“selling price” – total amount received, including cash, notes, debts assumed by buyer, and fair market value of services or property received.

“amount realized” – selling price less selling expenses (e.g., commissions, legal fees, and advertising).

“adjusted basis” – person’s original basis in the home, usually cost, plus capital improvements, minus depreciation claimed after May 6, 1997.

The amount realized minus adjusted basis results in the person’s realized gain or loss.  A loss on the person’s individual principal residence cannot be deducted.

Prior to May 7, 1997, a person who was at least 55 years of age could elect to exclude up to $125,000 of gain realized on sale of their homes [IRC 121(b)].  This was prior to amended Public Law; this election has been replaced with the $250K/$500K exclusion after May 7, 1997.

Limitation on exchange of personal residence after October 22, 2004.  President Bush signed into law changes affecting Internal Revenue Code Section 1031.  A taxpayer who exchanges under 1031 into a rental house as a replacement property that is later converted into their primary residence, is not allowed to exclude gain under principal residence exclusion rules of IRS 121 unless the sale occurs at least five years from the date of its acquisition.  The result is additional requirement to IRC 121 that anyone exchanging into rental property when they subsequently convert to personal use will have to wait at least five years from acquisition before they can sell it as their residence and exclude any gain under IRC 121(a). This is effective for principal residence sales occurring on or after October 22, 2004.  

[Source: U.S. Internal Revenue Service]
 

Harrison & Christi Long

Explore Group, Coldwell Banker Previews

949-854-7747

Explore Real Estate
The information contained herein is not the providing of legal services or services of an accountant.  If a person wants or needs such professional services, he or she must contact and retain counsel or a certified public accountant.  There are risks associated with the acquisition and ownership of real estate.