This article presents and applies the tax scheme for avoiding the taxation of profit taken on the sale of a principal residence.

Tax-free sale up to $250,000 per person

On the sale of a homeowner’s residence, up to $250,000 in profit per owner-occupant qualifies to be excluded from income and is not taxed. Thus, the increased value of a principal residence over the owner’s purchase price and cost of additional improvements is received tax-free on a sale or exchange of the residence, subject to several conditions, all of which most homeowners meet when they sell. [Internal Revenue Code §121]

A broker advising a homeowner on the timing of a sale of the owner’s residence to achieve the maximum profit exclusion from taxation must consider the qualifying conditions, including:

• Does the property qualify as the seller’s principal residence? [IRC §121(a)]
• Do the seller, the spouse, or other co-owner each qualify as owner and occupant for periods totaling two years during the five years preceding the close of the sale? [IRC §121(a)]
• If only one spouse is the vested owner, did the non-vested spouse also occupy the property as a principal residence for periods totaling two years during the five years prior to closing and did he or she not take a profit exclusion on the sale of a principal residence within two years prior to closing? The non-vested spouse then qualifies the couple for an additional $250,000 exclusion (the total now being $500,000) by filing a joint return. [IRC §§121(b)(2); (d)(1)]
• Did the homeowner disqualify himself by taking the profit exclusion on the sale of a different principal residence within two years before closing? [IRC §121(b)(3)]
• If sold prior to completing two full years of ownership and occupancy, or within two years after closing a sale on a prior principal residence and taking a profit exclusion, does the sale qualify for a pro rata amount of the $250,000 exclusion as a result of qualifying unforeseen difficulties? [IRC §121(c)(1),(2)]
• Did the homeowner take any depreciation deductions for a home office or rental of the property after May 6, 1997 which must be reported as unrecaptured gain (25% tax)? [IRC §121(d)(6)]
• If the seller is an unmarried surviving spouse who has not owned and occupied the property for the two-year period, will he qualify by tacking the deceased spouse’s period of ownership and occupancy? [IRC §121(d)(2)]
• If the owner is in a government-licensed facility, being physically or mentally incapable of taking care of himself (self care), and previously resided on the property for periods totaling at least one year during the past five years, does tacking the time spent in the facility while owning the property qualify the owner for the two-year ownership and occupancy requirements, and thus the $250,000 exclusion? [IRC §121(d)(7)]
• Is the seller the estate of a deceased homeowner or a person who inherited the property by will or living trust, and if so, did the deceased homeowner die after December 31, 2009 and own and occupy the property for the two-year period during the five years prior to the sale of the property? [IRC §121(d)(9)]

The principal residence or second residence

Occasionally, a couple will have two or  three residences that they occupy at different times during the year (a summer residence on the lake, a desert retreat, a residence in a prestigious community, etc.). On the sale of one of the residences at a profit, the question arises as to which home is the principal residence.

Identification of one of two or more residences as the principal residence is based initially on whether the owner seeking the $250,000 per person profit exclusion uses the property a majority of the time during the year.

A married couple, if qualified, can excluded an aggregate amount of up to $500,00 in profit taken on the sale of their principal residence.

Other factors the Internal Revenue Service (IRS) takes into consideration when two or more residences exist is whether the claimed principal residence is located near the owner’s employment, is used as the address listed on state and federal tax returns and is relatively close to banks and professional services used by the owner.

A sale also includes a principal residence subject to an involuntary conversion, such as destruction, theft, seizure, requisition or condemnation. Thus, all the rules for an exclusion of $250,000 would apply. [IRC §121(d)(5)]

For a married couple, the maximum possible exclusion of profit from taxation is $500,000, if both qualify. [IRC §121(b)(2)]

Profit exclusion for single individuals and co-owners

The amount of profit (or loss) taken on a sale of real estate is set by subtracting the seller’s cost basis in the property from the sales price he receives – a formula of “price minus basis equals profit.”

Profit taken by an individual on the sale of his principal residence may qualify for the $250,000 profit exclusion. To qualify, an individual must own and occupy the residence sold for at least two of the five years prior to closing the sale. [IRC §§121(a), (b)(1)]

The right to an exclusion on a particular sale is lost by the individual who has taken the exclusion on the sale of another principal residence which closed within two years of closing the sale of the current principal residence.

Thus, each individual who owns a principal residence, in whole or in part, and has occupied it for periods totaling two of the five years before closing the sale, can exclude up to $250,000 from his share of the profit on the sale of the property.

Consider an individual who occupies a property as his principal residence for one year. He then moves out, but retains ownership and rents the property.

More than four years after vacating the property, the individual reoccupies the property as his principal residence for one year before closing a sale of the residence at a profit.

Here, the individual occupied the property he owned as his principal residence for a total of two years. However, the individual did not occupy the property for a total of two years within the five-year period immediately preceding the sale, a requisite to excluding the profit from taxes. Thus, he cannot use the $250,000 exclusion to avoid taxes on the profit from the sale of the property. [IRC §121(a)]

Principal residence exclusion for married couples

A married couple who owns and occupies a property as their principal residence for at least two of the five years prior to the sale can, if not disqualified, exclude an aggregate amount of up to $500,000 in profit taken on the sale – $250,000 per person. [IRC §121(b)(2)]

For a husband and wife to qualify for the combined $500,000 profit exclusion on the sale of a principal residence:

• either may solely own the residence as separate property, or both may be co-owners, since ownership by one spouse alone is imputed to the non-owner spouse;
• both must occupy the property during the ownership for time periods totaling two years or more within the five years prior to the sale;
• the couple must file a joint return as a married couple for the year of sale; and
• neither spouse may have taken the $250,000 profit exclusion on another principal residence within two years prior to the sale. [IRC §121(b)(2)]

However, should either spouse be disqualified for having taken the principal residence profit exclusion on the sale of another residence which closed within two years prior to closing the sale of the current residence, the other spouse, owner or non-owner, qualifies for an individual $250,000 profit exclusion on their joint return. [IRC §121(b)(2)(B)]

Consider a husband who is the sole owner of a residence that is his separate property. The husband and his wife both occupy the property as their principal residence during his ownership. They do so for more than a total of two years during the five years immediately preceding the sale of the property.

Neither spouse has sold a principal residence during the two years prior to closing nor taken a $250,000 exclusion on any sale. The couple files a joint return for the year of sale.

Here, the couple qualifies to exclude up to $500,000 of profit taken on the sale of the residence, even though one spouse has no ownership interest in the real estate.

Now consider a husband and wife who each owned and occupied separate principal residences prior to their marriage. The wife sold her prior residence after getting married.

During the five years prior to the closing of the sale, the wife occupied her property as her principal residence for time periods totaling at least two years. For the year of the sale of the wife’s residence, the husband and wife file a joint return.

Can the couple take a $500,000 profit exclusion since the property was sold during the marriage?

No! Only a $250,000 exclusion from profit is allowed. The husband does not qualify for an additional $250,000 profit exclusion since he did not also occupy (for two years) the residence his wife owned and sold.

Both spouses must occupy the residence for a period totaling two years for each to qualify for a $250,000 profit exclusion, whether one spouse or both own the property.

No marital taint to disqualify

Again consider a couple who individually own properties which each occupies as their individual principal residence for two consecutive years prior to their marriage.

On marriage, the husband and wife both relocate to a newly-acquired residence. Each spouse needs to sell their prior residences.

The husband sells his prior residence at a profit. The couple files a joint return for the year of the sale.

Here, only the husband qualifies and may take the $250,000 profit exclusion on the couple’s joint tax return. The wife did not also occupy the property sold as her principal residence for two of the five years prior to the sale of the property.

Within two years after the husband closes the sale on his prior residence, the wife closes the sale of her prior residence at a profit. The wife, having owned and occupied her individual residence for two of the past five years, qualifies for a $250,000 profit exclusion. The husband and wife file a joint return for the year the wife sold her residence and claim the wife’>s $250,000 profit exclusion.

Here, the wife is qualified to take the individual $250,000 profit exclusion – even if the husband sold and took a $250,000 profit exclusion within two years of her sale. [IRC §121(b)(3)(A)]

In contrast, consider a man who, either prior to or after getting married, closes escrow on the sale of his principal residence and takes a profit.

The man owned and occupied the principal residence for time periods totaling more than two years during the five years prior to closing the sale. A $250,000 profit exclusion is taken on the sale.

Since their marriage, both the man and his wife have occupied as their principal residence the wife’s separate property for periods totaling at least two years within the past five years.

Less than two years after the husband closed the sale on which he took the $250,000 profit exclusion, the residence owned by his wife is sold and escrow closed.

Can the couple file a joint return and qualify for the $500,000 profit exclusion by reason of their marriage, the wife’s separate ownership and their shared occupancy of the residence?

No! Only the wife qualifies for a $250,000 profit exclusion on their joint return.

Even though the husband met the (imputed) ownership and (actual) occupancy requirements for the property sold by his wife, the husband took a $250,000 profit exclusion on the sale of his prior principal residence which closed within the two-year period immediately before the closing of the sale of the wife’s residence. Thus, the couple does not qualify for the total $500,000 profit exclusion. [IRC §121(b)(3)(A)]

Similarly, had the second residence sold been community property and not separately owned by the wife, only the wife would have been allowed to take a $250,000 profit exclusion on their joint return.

Closing the sale of the residence they both occupied should have been delayed to a date more than two years after the sale closed on the husband’s residence. If the sale had been delayed, the couple, one owning and both occupying for the required two-year period, would have qualified for the combined $500,000 profit exclusion.

Unoccupied at time of sale

An individual or married couple need not occupy a property as a principal residence at the time the property is purchased or sold to qualify for the $250,000 or combined $500,000 profit exclusion.

Consider a married couple who acquires a property and occupies it continuously as their principal residence for over two years.

Later, the couple buys another property and moves in, occupying it as their principal residence. The couple rents the old residence to a tenant, converting it into a depreciable income property.

Within three years after moving out of their prior residence, the couple sells the prior residence and takes a profit. The couple files a joint tax return for the year of the sale.

Here, the couple may properly take a $500,000 profit exclusion on the sale. The couple owned and occupied the prior residence as their principal residence for at least two of the last five years and neither was disqualified by having taken a $250,000 profit exclusion for the sale of a prior principal residence which closed within the two-year period preceding the current sale.

Checklist for principal residence profit exclusion
Occupancy:	Two years minimum as the principal residence of the taxpayer during the five-year period prior to closing the sale.
Ownership:	Held by the taxpayer from commencement of occupancy or by the taxpayer’s spouse if the spouse also qualifies for occupancy.
Two-year restriction:	Exclusion disallowed on a sale within two years of taxpayer’s use of the exclusion.
Exclusion amount:	$250,000 per taxpayer who qualifies as an owner-occupant or $500,000 for a couple filing a joint return if one or both spouses have ownership and both qualify as occupants.

An orderly liquidation

Now consider a married couple who has occupied their principal residence for over two years. They also own, either separately or as community property, several single-family residential rental properties.

The couple sells their principal residence and takes a profit of $300,000 on the sale. They file a joint tax return for the year of the sale and take the $500,000 profit exclusion – avoiding any tax on the $300,000 profit.

The couple then moves into one of the residential rental units they co-own, converting its use to their principal residence.

Two years after occupying the residential rental unit as their principal residence, the couple sells the unit and takes a profit. The couple files a joint tax return for the year of sale and uses the $500,000 profit exclusion to avoid taxes on the profit.

They then move into another rental unit owned by one of them separately, also converting its use to their principal residence. The unit they move into will be sold after two years of occupancy.

Again the couple will use the $500,000 profit exclusion to shelter any profit taken on the sale from taxes.

Thus, by repeating the two-year occupancy of single-family residences they own as their principal residence, the couple is able to:

• liquidate their real estate holdings; and
• avoid paying tax on the profit taken on the sales.

Should the couple carry back a note and trust deed on the sale of one of the properties, the profit allocated to the principal in the note will be declared in the year of sale and excluded from taxation as part of the $500,000 exclusion of profit on the sale. [IRC §453]

Unforeseen difficulties

Even if an individual or couple cannot fully meet the two-year ownership and occupancy requirements, they may still qualify to exclude profit up to a prorated portion of the $250,000 profit exclusion on the sale of a principal residence based on the portion of the two years they did occupy when the sale is due to:

• a change in employment based on factors of concurrent occupancy and job relocation, and the financial need to relocate for employment;
• a change in health, such as advanced age-related infirmities, severe allergies or emotional problems; or
• unforeseen circumstances which include natural or man-made disasters, death and divorce. [IRC §121(c)(2); Temporary Revenue Regulations §1.121-3T]

To qualify for a reduced exclusion, the owner’s primary reason for the sale of his principal residence must be a change in the place of employment.

A change in location of the job workplace may qualify the homeowner for a reduced maximum exclusion of less than $250,000 profit on the sale of his principal residence without first owning and occupying it for the full two-year period.Employment compelling the homeowner to relocate can be based on a required job relocation by his current employer, or the commencement of employment with a new employer, or if self-employed, the relocation of the place of business or the commencement of a new business.

For the sale to qualify for a reduced exclusion, the primary reason for the sale must be a change in the place of employment. Factors used to determine whether the primary reason for the sale is a change in the place of employment include:

• the need to relocate must arise during the occupancy of the residence sold;
• the sale of the principal residence and the homeowner’s need to relocate are close in time;
• the need to relocate was not foreseeable by the homeowner when he acquired and first occupied the principal residence sold;
• the principal residence is no longer suitable as the principal residence due to the place of employment;
• the homeowner’s financial ability to carry the residence requires the residence be sold.

Some sales because of a relocation to a new place of employment are “deemed” to be a change without concern for the factors supporting a primary reason, such as:

• if employed, the new job location is 50 miles farther from the sold principal residence than the old job; or
• if unemployed, the job location is at least 50 miles from the residence sold.

Thus, when a homeowner must sell because of unforeseen difficulties, profit is excluded based on a pro rata amount of the $250,000 per person exclusion due to the portion of the two years the owner actually owned and occupied the property as his principal residence. [IRC §121(c)(1)]

For example, a homeowner is forced by his employment to relocate out of the area.

The homeowner has owned and occupied his principal residence for one year and six months – 75% of the necessary two-year occupancy period.

The homeowner sells his residence, taking a $40,000 profit.

When filing his tax return, the homeowner will be able to exclude the entire $40,000 since the entire profit is less than 75% of the $250,000 exclusion. The same ratio would apply to a couple’s $500,000 profit exclusion under the same circumstances. [IRC §121(c)]

There are currently no comments highlighted. - ft

Copyright © 2012 by the first tuesday Journal Online - firsttuesdayjournal.com;
P.O. Box 5707, Riverside, CA 92517

Readers are encouraged to reproduce and/or distribute this article.

Copyright © 2012 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 5707, Riverside, CA 92517.