The overwhelming bulk of letters and e-mail I have received regarding the new Act involves the provision for the sale of a principal residence. If you sell your residence after May 6, 1997, you may exclude up to $250,000 of your capital gain provided you have owned and lived in your residence an aggregate of at least 2 of 5 years prior to sale (the "ownership" and "use" test). You may tack on ownership and use of a prior residence, as long as you rolled over the gain from the sale of your prior residence to your current residence under prior law (IRC Section 1034). The new exclusion applies to one home sale per two-year period, for sales occurring after the effective date.
The previous IRC Section 1034 rules and the once-in-a-lifetime exclusion of $125,000 are repealed, although those who sold their homes, or acquired replacement homes, prior to August 5, 1997, may apply those rules.
Married couples filing jointly may exclude up to $500,000 in gain, provided: (1) either spouse owned the residence; (2) both spouses meet the use test; and (3) and neither spouse has sold a residence within the last two years.
If a married couple each owns and occupies a separate residence and files jointly, each may exclude up to $250,000 in gain. Also, if it is a new marriage and one spouse sold a residence within 2 years before the marriage, the other spouse may exclude up to $250,000 in gain on a residence owned prior to the marriage.
Suppose a single man who owns a house with a $500,000 profit has lived in there for the past 10 years as his principal residence. During the past 2 years, he has been living with his girlfriend. He sold his house in September 1997. Should he get married by the end of the year? Yes, the statute focuses on filing a joint return and the couple is eligible to file a joint return if they are legally married by midnight, December 31, 1997. Therefore, as long as the residence was sold after the date of enactment, it does not matter whether the couple was married before or after the sale occurred, as long as they were married by the end of the year.
The two-year period begins when a person acquires the principal residence by purchase, gift or inheritance. If the new residence was acquired in a transaction in which gain was not recognized under form IRC Section 1034 (a tax-free rollover of a principal residence), taxpayers may tack on the ownership and use from a series of prior residences that made use of IRC Section 1034, if the gain from those transactions has been rolled over into the current residence.
Note: You may sell your present residence within 2 years from the date of your roll-over: The one sale per two-year requirement does not apply to IRC Section 1034 transactions occurring before the Act’s effective date.
Example: Taxpayer owned and used a former principal residence from 1990 to January 15, 1996. He used an IRC Section 1034 to rollover the gain from the sale of his former residence to his present residence on July 1, 1997. The two-year requirement for ownership and use is met and the new residence may be sold immediately, since the ownership and use from the prior residence is added to these requirements for the new residence. In contrast, if the taxpayer purchased a new residence for the first time (or acquired a residence by gift or inheritance) on December 15, 1996, he would have to wait until December 15,1998 to take advantage of the new exclusion.
Divorced taxpayers may tack on the ownership and use of their former spouse. Widowed taxpayers may tack on the ownership and use of their deceased spouse. But expatriates under IRC Sec. 877 (a)(1) cannot use this exclusion provision at all.
A partial exclusion is available if a residence is sold prior to the two-year-use requirement, because of a change in employment, health or unforeseen circumstances.
Under the technical corrections bill pending in Congress, taxpayers apply the exclusion ($250,000 or $500,000) to the percentage of use which is determined by the months of use prior to sale, divided by 24. Example: If a taxpayer eligible for a $250,000 exclusion sells a house for $50,000 and met 12 months of the use test, the entire $50,000 would be excluded since the maximum exclusion would be $125,000 (12/24 X $250,000 = $125,000 ).
The technical corrections bill changes an unfavorable IRS interpretation which would have excluded only 50% of the gain under the example. The IRS computed the exclusion percentage determined by the months of use prior to sale, divided by 24. Example: If a taxpayer sells a house for $50,000 and met 12 months of the use test, then $25,000 would be excluded ($50,000 X 12/24 = $25,000).
For those living in a nursing home, the ownership and use test is lowered to 1 out of 5 years prior to entering a facility. Time spent in the nursing home still counts toward ownership time and use of the residence. For example, if a taxpayer owns and lives in a home for 1 year, resides in a nursing home for 10 years, then sells the residence, the exclusion will apply.
Current tax-free rollover provisions (IRC Section 1034) and the once-in-a-lifetime exclusion of $125,000 (IRC Section 121) have been eliminated. Sales of a remainder interest may qualify for this exclusion. Also, a married couple who each own their principal residence may exclude $250,000 on the sale of a residence, provided they filed separate returns.
The exclusion does not apply to depreciation allowable on residences after May 6, 1997. Therefore, taxpayers should reconsider using a portion of their homes as offices, since the depreciation will be taxed at 25%. This amount, however, should not diminish the $500,000 tax-free portion.
Example: If a married couple sells a home with an adjusted basis of $100,000 for $750,000 and $50,000 is subject to recapture, their taxes should be determined as follows: Taxable gain: $750,000 - $100,000 = $650,000. Amount subject to 25% capital gain = $50,000; amount tax-free: $500,000; amount subject to 20% capital gain = $100,000. Taxpayers should exercise caution regarding the home office deduction, given the adverse treatment of real estate depreciation. Depreciation deductions incurred through a home office deduction will be taxed at a 25% capital gains rate, whereas, gain from the sale of a principal residence will be untaxed up to $500,000 for couples ($250,000 for individuals) under the new rules.
The effective date is for all sales or exchanges of principal residences occurring after May 6, 1997. Taxpayers may elect to apply present law to sales occurring before August 5, 1997, after August 5, 1997, pursuant to a binding contract entered into before that date, or where the replacement property was acquired before the date of enactment and the rollover provisions would otherwise apply.
Those with huge gains in their residences should consider using a portion of their home as investment property or having their children meet the ownership and use tests.
For example, a married taxpayers’ residence has a potential gain of $750,000. By converting 1/3 into investment property, then selling the 2/3 residential for $500,000 and using the IRC Section 1031 tax-free exchange provisions for the 1/3 investment portion, the entire transaction becomes tax-free (Note: IRC Section 1031 has stringent requirements that must be met).
For example, if a married couple owns a residence with their adult son who meets the ownership and use tests and who pays 1/3 of the costs, the son may sell his share for $250,000 gain without incurring a tax. His parents could then sell their share for $500,000 without tax, thereby sheltering the entire $750,000 gain.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**