Tax Planning

Principal Residence Gain Exclusion Break

Bradford Tax Institute

In this newsletter:

PART 1

With residential real estate markets surging, significant unrealized gains are piling up for many homeowners.

That’s good news if you’re ready to sell, but what about the tax implications? Good question.

Thankfully, the federal income tax gain exclusion break for principal residence sales is still on the books, and it’s a potentially big deal for prospective sellers. If you’re unmarried, the exclusion can shelter up to $250,000 of home sale gain. If you’re married, it can shelter up to $500,000. (1) That can really help!

This is a refresher course on understanding the twists and turns necessary to realize the maximum federal income tax savings out of the home sale gain exclusion break, which might be more valuable than ever right now. Let’s get started.

Gain Exclusion Basics

Unmarried homeowners can potentially exclude gains up to $250,000, and married homeowners can potentially exclude up to $500,000. You as the seller need not complete any special tax form to take advantage.

Report the taxable part of any principal residence gain on Schedule D of Form 1040. The current maximum federal rate for long-term capital gains is 20 percent or 23.8 percent if you owe the 3.8 percent net investment income tax (NIIT). These rates assume that lawmakers will enact no retroactive tax rate increase on gains recognized in 2021.

If part of your gain is taxable due to business or rental use of the home, you must also complete Form 4797 (Sales of Business Property). On Form 4797, you’ll calculate how much of your gain is subject to the special 25 percent maximum federal income tax rate on real property business or rental gains that are attributable to depreciation deductions. (2) (Some prefer to think of this as the recapture tax on real property deductions.)

Warning. As explained later, you can claim a full gain exclusion only once during any two-year period.

 

Pass the Ownership and Use Tests

To take full advantage of the principal residence gain exclusion break, you must pass two tests: the ownership test and the use test.

  • To pass the ownership test, you must have owned the home for at least two years out of the five- year period ending on the sale date.
  • To pass the use test, you must have used the home as your principal residence for at least two years out of the five-year period ending on the sale date.

Key point. These two tests are completely independent. In other words, periods of ownership and use need not overlap. For purposes of the two tests, two years means periods aggregating to 24 months or 730 days. (3)

 

What Counts as a Principal Residence?

Good question. IRS regulations say you must evaluate all facts and circumstances to determine whether or not a property is your principal residence for gain exclusion purposes.

If you occupy several residences during the same year, the general rule is that the principal residence for that particular year is the one where you spent the majority of time during that year. Other relevant factors can include, but are not limited to, the following: (4)

  • Where you work.
  • Where family members live.
  • The address shown on your income tax returns, driver’s license, and auto registration and voter registration cards.
  • Your mailing address for bills and correspondence.
  • Where you maintain bank accounts.
  • Where you maintain memberships and religious affiliations.

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Example 1. You’re unmarried and own one home in New Jersey and another in Arizona. During 2017-2021 (five years), you spend seven months each year in the New Jersey home and the remaining five months in the Arizona home. You sell both properties on December 31, 2021, the day escrow closes. Barring unusual circumstances, tax law treats the New Jersey home as your principal residence, and you can claim the gain exclusion privilege only for that property.

Even though you owned and used the Arizona home as a residence for an aggregate of 25 months during the five-year period ending on the sale date, you cannot claim the gain exclusion for that property, because it was not your IRS-defined principal residence at any time during the five-year period. (5)

Planning point. You look at each year for the principal residence. In this example, the New Jersey home is the principal residence for each of the five years.

But don’t give up hope. IRS regulations confirm that it’s possible to simultaneously pass the ownership and use tests for two residences, as illustrated by the next example.

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Example 2. You’re unmarried and own one home in Vermont and another in Florida. During 2017 and 2018, you lived in the Vermont home.

During 2019 and 2020, you lived in the Florida home.

During 2021, you once again live in the Vermont home.

In this specific scenario, you would qualify for the gain exclusion privilege if you sell either home in 2021, because you pass the two-out-of-five-years ownership and use tests for both homes. But if you sell both homes in 2021, you may claim the gain exclusion on one sale only. (6)

The double dip you were hoping for is prohibited by the anti-recycling rule explained later.

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Special Considerations If You’re Married

If you’re married and you and your spouse file your tax returns separately, you can potentially qualify for two separate $250,000 exclusions, as illustrated by the following example.

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Example 3. You and your spouse have jointly owned a greatly appreciated home for years and have used as your principal residence for years. For various reasons, you and your spouse file separate federal income tax returns. That precludes eligibility for the $500,000 joint-filer gain exclusion.

But thankfully, you and your spouse qualify for separate $250,000 exclusions because you both pass the ownership and use tests.

So, if you sell your home for a big gain, you can take advantage of a $250,000 gain exclusion, and your spouse can do the same—for a total of $500,000. No problem!

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If you’re married and file jointly, you qualify for the $500,000 joint-filer exclusion if: (7)

  • either you or your spouse pass the ownership test for the property and
  • both you and your spouse pass the use test.

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Example 4. Fred and Fran married after a whirlwind romance that began on a cruise ship. Immediately following the marriage, Fred sells his home for a $600,000 gain. He had owned and used the home as his principal residence for many years before he met Fran.

The newly married couple files a joint return for the year of sale.

Unfortunately, they don’t qualify for the larger $500,000 joint-filer exclusion because Fran does not pass the use test for the property. Therefore, the couple must report a whopping $350,000 taxable gain on their joint Form 1040 ($600,000 – $250,000 single exclusion). (8) Ugh!

What could have been. Instead of selling immediately, the couple could have lived together in Fred’s home for at least two years after the marriage. That way, they would have qualified for the larger $500,000 joint- filer exclusion—because Fred would have passed the ownership test and both Fred and Fran would have passed the use test. Oops!

Here’s another thought. Fred and Fran could have lived in Fred’s home for two years before marriage, gotten married, and then qualified for the $500,000 exclusion.

Key point. When only one spouse passes both tests, as in this example, the maximum gain exclusion is generally only $250,000. But in our Part 2 of this analysis, which we will publish on September 1, we will explain how a prorated (reduced) gain exclusion of more than $250,000 may be available when a married joint-filing couple fails to pass both tests. Stay tuned for that.

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When you file jointly, it’s possible for both you and your spouse to individually pass the ownership and use tests for two separate residences. In that case, you and your spouse would qualify for two separate $250,000 exclusions. (9)

Each spouse’s eligibility for the $250,000 exclusion is determined separately, as if you were unmarried. For this purpose, a spouse is considered to individually own a property for any period the property is actually owned by either spouse. (10)

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Example 5. Wanda and Willie have a “commuter marriage.” Wanda works in Denver and lives most of the time in the couple’s jointly owned condo there.

Willie works in Scottsdale and lives in the couple’s jointly owned townhouse there.

On some weekends, one spouse flies to the other’s city, and they both stay in their abode in that location. Under these facts, the larger $500,000 joint-filer exclusion is not available for either home, because both spouses must pass the use test in order for a residence to qualify for the $500,000 exclusion.

But separate $250,000 exclusions are potentially available for each residence. Assume both homes have been owned jointly by the couple for five years and that Wanda passes the use test for the Denver home while Willie passes the use test for the Scottsdale home.

Under these specific facts, Wanda would qualify for a $250,000 exclusion if the Denver home is sold and Willie would qualify for a separate $250,000 exclusion if the Scottsdale home is sold. (11)

Since each spouse’s eligibility for a $250,000 exclusion is determined separately, the two homes could be sold within two years of each other (or even in the same year) without violating the anti-recycling rule explained later. In other words, two separate $250,000 exclusions could be claimed for Wanda’s and Willie’ sales, even if the two sales are close together in time.

Variation. The results would be the same even if Wanda separately owns the Denver home and Willie separately owns the Scottsdale home. That’s because under the rules for joint filers, Wanda is considered to own any home actually owned by Willie, and Willie is considered to own any home actually owned by Wanda. (12)

That means Wanda would still pass the ownership and use tests for the Scottsdale home, and Willie would still pass the ownership and use tests for the Denver home.

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Special Rule for Unmarried Surviving Spouses

As stated earlier, an unmarried individual can potentially exclude up to $250,000 of gain from selling a principal residence while a married joint-filing couple can exclude up to $500,000.

But if you’re a surviving spouse, you’re not allowed to file a joint return for years after the year in which your spouse died—unless you remarry. So, you’re precluded from taking advantage of the larger $500,000 joint-filer exclusion. Thankfully, there’s an exception to this unfavorable general rule.

Under the exception, an unmarried surviving spouse can claim the larger $500,000 exclusion for a principal residence sale that occurs within two years after the spouse’s death, assuming all the other requirements for the $500,000 exclusion were met immediately before the spouse died. (13)

Key point. The two-year eligibility period for the larger exclusion begins on the date of the deceased spouse’s death. Therefore, a sale that occurs in the second calendar year following the year of death but more than 24 months after the deceased spouse’s date of death won’t qualify for the larger $500,000 exclusion.

 

Beware of Anti-Recycling Rule

The other big qualification rule for the home sale gain exclusion privilege goes like this: the exclusion is generally available only when you have not excluded an earlier gain within the two-year period ending on the date of the later sale. (14) In other words, you generally cannot recycle the gain exclusion privilege until two years have passed since you last used it.

You can claim the larger $500,000 joint-filer exclusion only if neither you nor your spouse took advantage of it for an earlier sale within the two-year period. (15) If one spouse claimed the exclusion within the two-year window, but the other spouse did not, the exclusion is limited to $250,000.

All the earlier explanations assume that you are unaffected by the anti-recycling rule. If you are affected, you are not eligible for the gain exclusion privilege unless:

  • You are eligible for a prorated (reduced) gain exclusion under rules that we will cover in Part 2 of our analysis in the September issue, or
  • You “elect out” of the gain exclusion privilege for the earlier sale, as explained below.

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Example 6. Bennie is unmarried and an optimistic fellow. He sold his original principal residence on July 1, 2020, and excluded $250,000 of gain.

Before selling that home, Bennie purchased another property on January 1, 2020 (six months earlier), and began using it as his new principal residence.

On March 1, 2022, he decides to sell the latest home, thinking he will qualify for another gain exclusion because he owned the latest property and used it as his principal residence for more than two years. Oops! While Bennie does pass both the two-out-of-five-years ownership and use tests with flying colors on the new residence, he violates the anti-recycling rule on the old residence that was sold on July 1, 2020.

Therefore, he is ineligible to exclude any gain from his 2022 sale. (16)

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When to “Elect Out” of the Gain Exclusion Privilege

As a home seller, you always have the option of “electing out” of the gain exclusion deal and reporting your home sale profit as a taxable gain. (17) You make the “election out” by reporting an otherwise excludable gain on Schedule D of Form 1040 for the year of sale. No further action is required to “elect out.” (18)

Note that you can retroactively election out or revoke an earlier election out by filing an amended return at any time within the three-year period beginning with the filing deadline (without regard to any extension) for the year-of-sale return. (19)

An obvious circumstance where the election out can be beneficial is when you have two principal residence sales within a two-year period, with the later sale producing a larger gain. Consider the following example.

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Example 7. You are a married joint filer. You and your spouse jointly own a home in Austin, Texas, and another in Beaver Creek, Colorado. You and your spouse used the Austin property as your principal residence in 2017 and 2018.

The two of you used the Beaver Creek home as your principal residence in 2019 and 2020.

In early 2021, you sell the Austin property for a $300,000 gain. Later in 2021, you sell the Beaver Creek home for an $800,000 gain.

You and your spouse meet the two-out-of-five-years ownership and use tests for both properties. But since the Beaver Creek property was sold less than two years after the sale of the Austin property, you cannot claim the gain exclusion break for the Beaver Creek sale, because that would violate the anti-recycling rule.

Under these specific facts, you should elect out of the gain exclusion privilege for the Austin sale. You can then exclude $500,000 of gain from the more-profitable Beaver Creek sale.

Make the election out by reporting the $300,000 profit from the Austin sale on Schedule D included with your 2021 joint Form 1040.

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Takeaways

In a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver. It’s one of the most valuable tax breaks for individual taxpayers.

You must pass the ownership and use tests and avoid the anti-recycling rule to claim the maximum gain exclusion of $250,000 or $500,000 for a married joint-filing couple.

If you can’t do all of the above, you may still qualify for a prorated (reduced) gain exclusion in circumstances that we will explain in next month’s Part 2 of our analysis.

 

1 IRC Section 121.
2 So-called unrecaptured Section 1250 gains.
3 Reg. Sections 1.121-1(c)(1), 1.121-1(c)(2).
4 Reg. Section 1.121-1(b)(2).
5 Reg. Section 1.121-1(b)(4), Example 1.
6 Reg. Section 1.121-1(b)(4), Example 2.
7 IRC Section 121 (b)(2)(A).
8 Reg. Section 1.121-2(a)(4), Example 4.
9 IRC Section 121(d)(1).
10 Reg. Section 1.121-2(a)(3)(ii).
11 Reg. Section 1.121-2(a)(4), Example 3.
12 Reg. Section 1.121-2(a)(3)(ii).
13 IRC Section 121(b)(4).
14 IRC Section 121(b)(3).
15 IRC Section 121(b)(2)(A)(iii).
16 Reg. Section 1.121-2(b).
17 IRC Section 121(f).
18 Reg. Section 1.121-4(g).
19 Ibid.

 

PART 2

Take Advantage of the Prorated (Reduced) Gain Exclusion Loophole for “Premature” Sales

What happens when you:

  • fail to pass the principal residence gain exclusion ownership and use tests explained in Part 1 of our analysis, or
  • run afoul of the anti-recycling rule explained above.

Are you just flat out of luck for the gain exclusion? Maybe not.

For example, perhaps you are selling your home for a big profit after living there for only 18 months instead of the required two years, so you fail the ownership and use tests. Or you might be selling your current home less than two years after excluding gain from the sale of a previous residence, so you violate the anti-recycling rule. Rats!

Don’t give up hope.

IRS regulations allow you to claim a prorated (reduced) gain exclusion—a percentage of the $250,000 or $500,000 exclusion that might otherwise be available—in designated circumstances, as you are about to see.

The prorated gain exclusion equals the full $250,000 or $500,000 figure (whichever would otherwise apply) multiplied by a fraction.

The numerator is the shorter of (2):

  • the aggregate period of time you owned and used the property as your principal residence during the five-year period ending on the sale date, or
  • the period between the last sale for which you claimed an exclusion and the sale date for the home currently being sold.

The denominator is two years, or the equivalent in months or days.(3)

When you qualify for the prorated exclusion, it might be big enough to shelter the entire gain from making a premature sale. But the prorated exclusion loophole is available only when your premature sale is due primarily to:

  • a change in place of employment,
  • health reasons, or
  • specified unforeseen circumstances.

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Example 1. You’re a married joint-filer. You’ve owned and used a home as your principal residence for 11 months. Assuming you qualify, your prorated joint gain exclusion is $229,167 ($500,000 x 11/24). Hopefully, that will be enough to avoid any federal income tax hit from the sale.

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Example 2. You’re unmarried. You sold your previous home 15 months ago and excluded the gain. Now you’re about to sell your current home, which you’ve owned and used as your principal residence for 21 months. You bought the current home and occupied it for six months before selling the previous home.

Assuming you qualify, your prorated gain exclusion is $156,250 ($250,000 x 15/24). Hopefully that will be enough to avoid any federal income tax hit from selling your current home.

The gain exclusion that you claimed on the sale of your previous home is completely unaffected by all this.

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Premature Sale Due to Employment Change

Per IRS regulations, you’re eligible for the prorated gain exclusion privilege whenever a premature home sale is primarily due to a change in place of employment for any qualified individual. Qualified individual means the taxpayer (that would be you), the taxpayer’s spouse, any co-owner of the home, or any other person whose main residence is within the taxpayer’s household. (4)

A premature sale is automatically considered to be primarily due to a change in place of employment if any qualified individual passes the following distance test: the distance between the new place of employment/self employment and the former residence (the property that is being sold) is at least 50 miles more than the distance between the former place of employment/self-employment and the former residence.

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Example 3. You run your sole proprietorship business out of your home, which you’ve decided to sell after having owned and used it as your principal residence for only 19 months. You then buy a new home 65 miles away and run your business out of the new home.

According to these facts, you pass the 50-mile test because your new place of self-employment (the new house) is 65 miles farther away from your former home than was your old place of self-employment (the old house which was, obviously, zero miles away from itself).

Therefore, you qualify for a prorated gain exclusion. If you’re a married joint-filer, the prorated exclusion is $395,833 ($500,000 x 19/24). If you’re unmarried, the prorated exclusion is $197,917 ($250,000 x 19/24).

But note that you will be taxed on any gain attributable to depreciation from post-May 6, 1997, business or rental use of the home you sold, as explained later.

(But also note that on the business part of the home, you can use Section 1031 to defer and even avoid taxes. For details on this strategy, see Beat the Recapture Tax on Your Home Office.)

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Example 4. Dante is married and files jointly with his wife, Clara. As an emergency room physician, Clara must live close to the hospital where she works, so the couple’s home is only three miles away. Now Clara becomes employed by a different hospital. As a result, they sell their home.

But they owned and used this home as their principal residence for only 22 months. Dante and Clara then rent a townhouse that’s only five miles away from her new job location. Assume her new job is 42 miles away from the old residence that was sold.

Dante and Clara fail the 50-mile test, because Clara’s new job is only 39 miles farther away from the old home than was her old job (42 miles versus 3 miles).

But again, due to the nature of Clara’s work, she must live close to her place of employment. Her facts and circumstances clearly show the premature sale of the former home was primarily due to a change in the place of Clara’s employment.

Consequently, Dante and Clara are eligible for a prorated gain exclusion of $458,333 ($500,000 x 22/24). (5)

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Key point. If you can’t pass the 50-mile test, obtain documentation showing that the premature home sale was primarily due to a qualified individual’s change in place of employment, assuming the facts so indicate (as in this example). That should prove your eligibility for the prorated gain exclusion loophole if you ever get audited on the issue.

 

Premature Sale Due to Health Reasons

Per IRS regulations, you are also eligible for the prorated gain exclusion privilege whenever a premature sale is primarily due to health reasons. You pass this test if your move is to:

  • obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or
  • obtain or provide medical or personal care for a qualified individual who suffers from a disease, an illness, or an injury.

For this purpose, qualified individual means:

  1. the taxpayer (that would be you),
  2. the taxpayer’s spouse,
  3. any co-owner of the home, or
  4. any person whose principal residence is within the taxpayer’s household.

In addition, almost any close relative of a person listed above also counts as a qualified individual. And any descendant of the taxpayer’s grandparent (such as a first cousin) also counts as a qualified individual. (6)

A premature sale will automatically be considered primarily for health reasons whenever a doctor recommends a change of residence for reasons of a qualified individual’s health (meaning to obtain, provide, or facilitate care, as explained above). If you fail the automatic qualification, your facts and circumstances must indicate that the premature sale was primarily for reasons of a qualified individual’s health.

You cannot claim a prorated gain exclusion for a premature sale that is merely beneficial to the general health or well-being of a qualified individual. (7)

Key point. Whenever possible, obtain a doctor’s recommendation in writing to prove that you are entitled to the prorated gain exclusion because your premature sale was primarily for reasons of a qualified individual’s health. Keep the doctor’s note with your tax records.

 

Premature Sale Due to Other Unforeseen Circumstances

Per IRS regulations, a premature sale is generally considered to be due to unforeseen circumstances if the primary reason for the sale is the occurrence of an event that you could not have reasonably anticipated before purchasing and occupying the residence.

But a premature sale that is primarily due to a preference for a difference residence or an improvement in financial circumstances will not be considered due to unforeseen circumstances, unless the safe-harbor rule applies.(8)

Under the safe-harbor rule, a premature sale is deemed to be due to unforeseen circumstances if any of the following events occur during your ownership and use of the property as your principal residence:

  • Involuntary conversion of the residence
  • A natural or man-made disaster or acts of war or terrorism resulting in a casualty to the residence
  • Death of a qualified individual
  • A qualified individual’s cessation of employment, making him or her eligible for unemployment compensation
  • A qualified individual’s change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household
  • A qualified individual’s divorce or legal separation under a decree of divorce or separate maintenance
  • Multiple births resulting from a single pregnancy of a qualified individual

For purposes of this safe-harbor rule, a qualifying individual is defined as (1) the taxpayer (again, that would be you), (2) the taxpayer’s spouse, (3) a co-owner of the residence in question, or (4) a person whose principal place of abode is in the same household as the taxpayer.(9)

Key point. If none of the preceding safe-harbor events occur, you can still qualify for a reduced gain exclusion if the facts and circumstances indicate the primary reason for your premature home sale was the occurrence of an event that you could not have reasonably anticipated before purchasing and occupying the residence.(10)

 

Premature Sales in Other Situations

If you cannot claim a prorated exclusion for a premature sale of your principal residence under any of the aforementioned specific rules, all is not necessarily lost.

You can still claim a prorated exclusion if, after considering all facts and circumstances, you can assert that the primary reason for your sale is deemed to be due to a change in place of employment, health issues, or unforeseen circumstances.

Factors that can help you make this claim as the primary reason for your premature sale include, but are not limited to, the following: (11)

Whether the premature sale and the circumstances giving rise to the sale are proximate in time

  • A material change in the suitability of the property as your principal residence
  • A material change in your financial ability to maintain the property
  • Whether you actually use the property as a residence during your ownership period
  • Whether the circumstances giving rise to the premature sale were reasonably foreseeable when you began using the property as a principal residence
  • Whether the circumstances giving rise to the premature sale actually occurred during the period
  • When you owned and used the property as a principal residence

 

Claim Gain Exclusion for Home Used Partly for Business or Rental

Say you use the basement of your principal residence as a deductible home office or rent out that space during the entire time you own the home. Then you sell the home. The profit on the residential part of your home could qualify for the gain exclusion. The profit on the business or rental part seemingly could not, because it was not used for residential purposes.

Thankfully, IRS regulations allow you to treat the entire home as a single property if the residential part and the business or rental part are within the same dwelling unit. (12) In that case, the entire property will qualify for the full $250,000 or $500,000 gain exclusion (whichever applies), as long as you meet the timing requirements for the residential part. Great!

Naturally, there’s an exception. You must include in your taxable income any gain up to the amount of depreciation deductions claimed for post-May 6, 1997, business or rental usage of the property.(13)

If the gain on the sale of the home is long-term, the depreciation on the office or rental is characterized as so-called unrecaptured Section 1250 gain that’s subject to a maximum federal income tax rate of 25 percent under current law. Since you’ve already reaped tax savings from the depreciation at your ordinary tax rate and possibly from self- employment taxes, this outcome is beneficial.

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Example 5. You are a married joint-filer. You use part of your home as a deductible office for your real estate sales business during your entire ownership period. You’ve claimed $10,000 of depreciation deductions for the office space. You sell the home for a $500,000 profit, including $10,000 attributable to the depreciation write-offs.

Assuming you meet all the gain exclusion timing requirements for the residential part of your property, you can exclude $490,000 of gain. The remaining $10,000 is taxable unrecaptured Section 1250 gain from depreciation that’s subject to a federal rate of up to 25 percent.(14)

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Example 6. The same basic facts apply as in the preceding example, except this time your office is in a detached building formerly used as a garage. You must treat the sale of your property as two separate transactions. Allocate the sales proceeds and tax basis between the detached building and the rest of the property, and calculate two separate gains. You cannot exclude the gain from selling the detached building.

Gain from the rest of the property (the part used as your principal residence) is eligible for the gain exclusion privilege, assuming you meet the timing requirements for that part of the property.(15)

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Example 7. You converted the basement of your home into a separate rental dwelling unit by installing kitchen and bathroom facilities and a separate outside entrance. When you sell the property, you must treat the sale as two separate transactions.

Allocate the sales proceeds and tax basis between the basement and the rest of the property, and calculate two separate gains. You cannot exclude the gain from selling the basement.

Gain from the rest of the property (the part used as your principal residence) is eligible for the gain exclusion privilege, assuming you meet the timing requirements for that part of the property.(16)

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As the preceding two examples illustrate, you should be thoughtful about business or rental usage of space that’s not within the same dwelling unit as your principal residence (for clarity, think within the walls). Why? Such use could trigger a taxable gain that you cannot shelter with your gain exclusion privilege.

Specifically, when the amount of gain allocable to the separate business or rental space would be considerable, you may want to avoid any business or rental usage during the two-year period preceding the sale date. That way, you will pass the two-out-of-five-years use test for the business or rental part of the property, and it will be eligible for the gain exclusion privilege.

And don’t forget the possibility of using a Section 1031 transaction on the portion of the property treated as a rental or a commercial office.

 

Premature Sale of Property Used for Business or Rental

What happens when you qualify for the prorated gain exclusion privilege upon a premature sale of a residence used partly for business or rental purposes? Good question.

Answer: calculate the prorated gain exclusion as explained earlier. Then use the prorated exclusion to shelter otherwise taxable gain, as explained in the immediately preceding discussion of homes used partly for business or rental purposes. You have three important things to remember here.

  1. As explained earlier, the prorated exclusion deal is available only for a premature sale that’s primarily due to (a) a change in a qualified individual’s place of employment, (b) reasons related to a qualified individual’s health, or (c) unforeseen circumstances.
  2. You cannot use the prorated home-sale exclusion to shelter gain attributable to any post-May 6, 1997, depreciation from business or rental use of the property.
  3. When the business or rental part of the property is not within the walls of the same dwelling unit as the principal residence, the prorated exclusion can be used to shelter only gain allocable to the residential part of the property. Any profit on the separate business or rental part is fully taxable.

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Example 8. You’re unmarried, and you use part of your home as a deductible office for your real estate sales business during your entire ownership period. You’ve claimed $2,000 of depreciation deductions for the office space, which is not in a separate structure. After owning the home for only 18 months, you sell it for a $150,000 gain, including $2,000 attributable to the depreciation deductions. Your premature sale is primarily for reasons related to your health.

You are entitled to a prorated gain exclusion of $187,500 ($250,000 x 18/24), which is more than you need in this case. You can shelter $148,000 of your gain ($150,000 – $2,000 from depreciation) with the prorated exclusion. The $2,000 that you can’t shelter is unrecaptured Section 1250 gain from depreciation that’s subject to a federal rate of up to 25 percent. (17)

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Exclude Gain from Sale of Land Next to Your Residence

Per IRS regulations, you can potentially use the gain exclusion break to shelter profit from selling vacant land next to your principal residence. In fact, you can even sell the parcel with the home and the surrounding vacant land in completely separate transactions. Naturally, there are some ground rules (pun intended).

  1. The vacant land must be sold within two years before or after the sale of the parcel containing the house. Separate sales of the parcel containing the house and the adjacent vacant land within this four-year window do not violate the anti-recycling rule.
  2. The sale of the parcel containing the house must itself qualify for the gain exclusion.
  3. The vacant land must be adjacent to the parcel containing the house.
  4. The vacant land must have been owned and used as part of your principal residence, and the vacant land must pass the two-out-of-five-years ownership and use tests.

If you pass all these tests, you can use the gain exclusion privilege to avoid any federal income tax on gain of up to $250,000, or $500,000 if you’re a married joint-filer. Remember, here you are looking at the combined gains from selling the parcel containing the house and the adjacent vacant land. Understand that you get only one exclusion for the combined gains.(18)

For instance, an example in the IRS regulations says you could sell a one-acre parcel with your home in one transaction and a 29-acre adjacent parcel of vacant land in a separate transaction and use the gain exclusion to shelter the combined profits from the two sales. Presumably, the same favorable result would apply if the vacant land were sold in several separate transactions.

What happens if you sell the adjacent vacant land in advance of the parcel containing your house? Good question.

If the parcel with the house is not sold until after the due date of your Form 1040 for the year of the land sale, you must report the gain from the land sale on your return for that year. Then, after you sell the parcel containing your principal residence, file an amended return to exclude some or all of the earlier land sale gain. You generally have three years from the date you file the original Form 1040 to file an amended return, assuming you filed the original Form 1040 on time. (19)

 

Takeaways

In a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver.

You must pass the ownership and use tests and avoid the anti-recycling rule to claim the maximum gain exclusion of $250,000, or $500,000 for married joint-filers. See Part 1 of our analysis for details on these restrictions.

In this article, you learned how to take advantage of the prorated gain exclusion loophole for a premature sale when that sale is primarily due to a qualified individual’s:

  • change in place of employment,
  • health issues, or
  • specified unforeseen circumstances.

For this purpose, qualified individual means:

  1. the taxpayer (that would be you),
  2. the taxpayer’s spouse,
  3. any co-owner of the home, or
  4. any person whose principal residence is within the taxpayer’s household.

You also learned that the home sale gain exclusion applies to the gain from the residence part, including the office part if it is within the walls of the residence (say, a bedroom). But depreciation of an office or a rental inside the home does not qualify for the gain exclusion and is subject to the unrecaptured Section 1250 tax rate of up to 25 percent.

And finally, you learned special rules that apply to vacant land that is considered part of your personal residence.

 

1 IRC Section 121.
2 IRC Section 121(d)(1); Reg. Section 1.121-3(g).
3 Ibid.
4 Reg. Section 1.121-3(c).
5 IRS Reg. Section 1.121-3(c)(4), Example (4).
6 Reg. Section 1.121-3(f).
7 Reg. Section 1.121-3(d)(3), Example (5).
8 Reg. Sections 1.121-3(e)(1); 1.121-3(e)(4), Examples (7), (8), and (10).
9 Reg. Section 1.121-3(e)(2).
10 The regulations include three examples of non-safe-harbor situations that seem to indicate the IRS will be fairly liberal in this area. See Reg. Section 1.121-3(e)(4),
Examples (4), (6), and (9). The IRS can also designate other events as unforeseen circumstances, in published guidance of general applicability (such as revenue rulings)
or in rulings addressed to specific taxpayers (such as private letter rulings). But the guidance in the letter rule applies only to the specific taxpayers to whom the guidance is
directed. See Reg. Section 1.121-3(e)(3).
11 Reg. Section 1.121-3(b).
12 Reg. Section 1.121-1(e).
13 Reg. Section 1.121-1(d).
14 Reg. Section 1.121-1(e)(4), Example (5).
15 Reg. Section 1.121-1(e)(4), Examples (1) and (3).
16 Ibid.
17 See Reg. Section 1.121-1(e)(4), Example (5) in conjunction with Reg. Section 1.121-3.
18 Reg. Section 1.121-1(b)(3).
19 Reg. Section 1.121-1(b)(3).

 

PART 3

How to Exclude Gain in Marriage and Divorce Situations

In both marriage and divorce situations, a home sale often occurs. Of course, the principal residence gain exclusion break can come in very handy when an appreciated home is put on the block.

Sale during Marriage

Say a couple gets married. They each own separate residences from their single days. After the marriage, the pair files jointly. In this scenario, it is possible for each spouse to individually pass the ownership and use tests for their respective residences. Each spouse can then take advantage of a separate $250,000 exclusion. (2)

Put another way, each spouse’s eligibility for a separate $250,000 exclusion is determined independently, as if the couple were still unmarried. (3)

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Example 1. You get married and decide to move into your spouse’s home. You also own a home. Neither of you had lived in the other’s home before the marriage.

You and your new spouse file jointly. Shortly after the marriage, your spouse sells her home. You can exclude up to $250,000 of gain from that sale as long as your spouse:

  • owned and used the property as her principal residence for at least two years out of the five-year period ending on the sale date, and
  • did not exclude gain from any earlier sale within the preceding two years.

You may also decide to sell your home. You can exclude up to $250,000 of gain as long as you individually pass the same ownership and use tests. It does not matter if the sale of your home occurs within two years of the sale of your spouse’s home.

Variation. Assume the sale of your home would trigger a $450,000 gain. In that case, you and your spouse should:

  • live together in your home for at least two years, and
  • make sure at least two years have elapsed since the sale of your spouse’s home.

Then you can sell your home and be eligible for the larger $500,000 joint-filer exclusion. That would shelter your entire gain from any federal income tax hit. (4)

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Sale before Divorce

Say a soon-to-be-divorced couple sells their principal residence. Assume they still are legally married as of the end of the year of sale because their divorce is not yet final. In this scenario, the divorcing couple can shelter up to $500,000 of home sale profit in two different ways:

  • Joint return. The couple could file a joint Form 1040 for the year of sale. Assuming they meet the timing requirements, they can claim the $500,000 joint-filer exclusion.
  • Separate returns. Alternatively, the couple could file separate returns for the year of sale, using married-filing-separately status. Assuming the home is owned jointly or as community property, each spouse can then exclude up to $250,000 of his or her share of the gain.

To qualify for two separate $250,000 exclusions, each spouse must have: (5)

  • owned his or her part of the property for at least two years during the five-year period ending on the sale date, and
  • used the home as his or her principal residence for at least two years during that five-year period.

Key point. In many cases, the preceding favorable rules will allow the divorcing couple to convert their home equity into tax-free cash. They can generally divide up that cash any way they choose without any further federal tax consequences, and then go their separate ways. (6)

Sale in Year of Divorce or Later

When a couple is divorced as of the end of the year in which their principal residence is sold, they are considered divorced for that entire year. Therefore, they will be unable to file jointly for the year of sale. The same is true, of course, when the sale occurs after the year of divorce. Here’s the home sale gain exclusion drill in these situations.

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Example 2. Ex-spouse Andy winds up with sole ownership of the residence, which was formerly owned solely by ex-spouse Briana, in a federal tax-free divorce-related transfer. (7)

In this scenario, when Andy eventually sells the property, he is allowed to count Briana’s period of ownership for purposes of passing the two-out-of-five-years ownership test. (8)

Andy’s maximum gain exclusion will be $250,000, because he is now single.

But if he remarries and lives in the home with the new spouse for at least two years before selling, Andy ca qualify for the larger $500,000 joint-filer exclusion.

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Example 3. This time let’s say that ex-spouse Andy winds up owning some percentage of the home, while ex-spouse Briana winds up owning the rest. When the home is later sold, both Andy and Briana can exclude $250,000 of their respective shares of the gain, provided each person: (9)

  • owned his or her share of the home for at least two years during the five-year period ending on the sale date, and
  • used the home as his or her principal residence for at least two years during that same five-year period.

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Key point. Under the preceding rules, both ex-spouses will typically qualify for separate $250,000 gain exclusions when the home is sold soon after the divorce. But when the property remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-five-years use test and become ineligible for the gain exclusion privilege.

Let’s see how we can avoid that unpleasant outcome.

 

When the Non-Resident Ex Continues to Own the Home for Years after Divorce

Sometimes ex-spouses will continue to co-own the former marital abode for a lengthy period after the divorce. Of course, only one ex-spouse will continue to live in the home. After three years of being out of the house, the nonresident ex will fail the two-out-of-five-years use test. That means when the home is finally sold, the non-resident ex’s share of the gain will be fully taxable. But with some advance planning, you can prevent this undesirable outcome.

If you will be the non-resident ex, your divorce papers should stipulate that as a condition of the divorce agreement, your ex-spouse is allowed to continue to occupy the home for as long as he or she wants, or until the kids reach a certain age, or for a specified number of years, or for whatever time period you and your soon-to-be ex can agree on. At that point, either the home can be put up for sale, with the proceeds split per the divorce agreement, or one ex can buy out the other’s share for current fair market value.

This arrangement allows you, as the non-resident ex, to receive “credit” for your ex’s continued use of the property as a principal residence. So, when the home is finally sold, you should pass the two-out-of-five-years use test and thereby qualify for the $250,000 gain exclusion privilege. (10)

The same strategy works when you wind up with complete ownership of the home after the divorce, but your ex continues to live there. Stipulating as a condition of the divorce that your ex is allowed to continue to live in the home ensures that you, as the non-resident ex, will qualify for the $250,000 gain exclusion when the home is eventually sold.

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Example 4. Dave and Della are divorced in September 2021. Each party retains 50 percent ownership of the former marital abode.

A specific condition of the divorce agreement stipulates that Della is allowed to continue to reside in the home for up to six years, at which point the couple’s youngest child will reach age 18. Then Della must either buy out Dave’s 50 percent ownership interest based on market value at that time or cooperate in selling the home.

Assume the property is indeed sold six years after the divorce.

With respect to his 50 percent ownership interest, Dave still passes the two-out-of-five-years ownership and use tests even though he has not lived in the home for six years. That’s because he made sure the divorce agreement included the magic words: the provision specifically permitting Della to continue to reside in the home.

Because of the magic words, Dave can count Della’s continued use of the property as her principal residence as continued use by him. That means Dave will qualify for the $250,000 gain exclusion privilege when the home is sold, six years after the divorce. He can use the exclusion to shelter all or part of his share of the home sale profit.

Key point. If Dave’s attorney fails to include the magic words in the divorce papers, Dave will be taxed on his share of the home sale gain when the property is sold, six years after the divorce. Ugh!

Della also passes the ownership and use tests. So, she also qualifies for a separate $250,000 gain exclusion, assuming she remains single.

Say Della remarries during this six-year period. She and her new husband, Max, live in the home for at lea two years before the sale date. With respect to her share of the home sale gain, Della can qualify for the larger $500,000 exclusion by filing a joint Form 1040 with Max for the year of sale.

With respect to his share of the gain, Dave still qualifies for a $250,000 exclusion, as explained above.

___________________________________

Example 5. Assume the same basic facts as in the previous example, except this time Dave has 100 percent ownership of the former marital abode after the divorce. A specific condition in the divorce agreement stipulates that Della can continue to reside in the home for up to six years. After that, Dave can sell the home at any time by giving Della three months’ notice of his intent to sell.

The property is sold six years and three months after the divorce. Dave still passes the two-out-of-five-years ownership and use tests even though he has not lived in the home for over six years. So, he qualifies for the $250,000 gain exclusion privilege, which he can use to shelter all or part of his home sale profit.

Key point. As we noted earlier, if Dave’s attorney fails to include the magic words in the divorce agreement, Dave will be taxed on the entire home sale gain six years after the divorce. Ugh!

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Little-Known Non-Excludable Gain Rule Can Mean Unexpectedly Higher Taxes on a Property Converted into Your Principal Residence

Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the home sale gain exclusion privilege of $250,000 for unmarried individuals or $500,000 for married, joint-filing couples. Those were the good old days!

Unfortunately, legislation enacted back in 2008 included an unfavorable provision for personal residence sales that occur after that year. The provision can make a portion of your gain from selling an affected residence ineligible for the gain exclusion privilege. (11)

Let’s call the amount of gain that is made ineligible the non-excludable gain. The non-excludable gain amount is calculated as follows.

Step 1. Take the total gain and subtract any gain from depreciation deductions claimed against the property for periods after May 6, 1997. Include the gain from depreciation (so-called unrecaptured Section 1250 gain) in your taxable income.12 Carry the remaining gain to Step 3.

Step 2. Calculate the non-excludable gain fraction.

The numerator of the fraction is the amount of time after 2008 during which the property is not used as your principal residence. These times are called periods of non-qualified use.

But periods of non-qualified use don’t include temporary absences that aggregate two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance.

Periods of non-qualified use also don’t include times when the property is not used as your principal residence, if those times are:

  • after the last day of use as your principal residence, and
  • within the five-year period ending on the sale date. (See Example 10 below.)

The denominator of the fraction is your total ownership period for the property.

Step 3. Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.

Step 4. Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. Also report any Step 1 unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements.

___________________________________

Example 6. Emmy, a married joint-filer, bought a vacation home on January 1, 2013. On January 1, 2017, she converted the vacation home into her principal residence, and she and her spouse lived there from 2017 through 2021. On January 1, 2022, Emmy sells the property for a $600,000 gain. Her total ownership period is nine years (2013-2021).

The four years of post-2008 use as a vacation home (2013-2016) result in a non-excludable gain of $266,667 (419 x $600,000). Emmy must report the $266,667 on her 2022 Schedule D as a long-term capital gain and must absorb the resulting federal income tax hit.

She can shelter the remaining $333,333 of gain ($600,000 – $266,667) with her $500,000 gain exclusion.

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Example 7. Assume the same basic facts as in the preceding example, except this time assume that Emmy has $10,000 of unrecaptured Section 1250 gain from renting out the property before converting it into her principal residence. Therefore, the total gain on sale is $610,000.

  1. Emmy must report the $10,000 of unrecaptured Section 1250 gain on her 2022 Schedule D.
  2. She must also report the non-excludable gain of $266,667 [4/9 x ($610,000 – $10,000)] on her 2022 Schedule D.
  3. She can shelter the remaining $333,333 of gain ($610,000 – $10,000 – $266,667) with her $500,000 gain exclusion.

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Example 8. Freeman is a single guy. He bought a vacation home on January 1, 2009. On January 1, 2013, he converted the property into his principal residence, and he lived there for 2013-2021.

On January 1, 2022, he sells the property for a $700,000 gain. Freeman’s total ownership period is 13 yea (2009-2021). The four years of post-2008 use as a vacation home (2009-2012) result in a non-excludable gain of $215,385 (4/13 x $700,000).

Freeman qualifies for the $250,000 gain exclusion.

Ignoring the impact of the non-excludable gain rule, he must report a $450,000 gain on his 2022 Schedule D ($700,000 – $250,000). Since the $450,000 gain that he must report exceeds the $215,385 non- excludable gain, the non-excludable gain rule has no impact on Freeman. He reports a gain of $450,000 on his 2022 Schedule D.

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Example 9. Assume the same basic facts as in the preceding example, except this time assume that Freeman has only a $300,000 gain when he sells the property on January 1, 2022. Therefore, he has a non-excludable gain of $92,308 (4/13 x $300,000), which he must report on his 2022 Schedule D.

Freeman can use his $250,000 gain exclusion to shelter the remaining $207,692 of gain ($300,000 – $92,308).

Key point. The results in Examples 8 and 9 reveal the interesting truth that the non-excludable gain rule can hurt sellers with smaller gains while having no impact on sellers with larger gains.

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Example 10. Gemma is a married joint-filer. She bought a vacation home on January 1, 2013. On January 1, 2016, she converted the property into her principal residence, and she lived there with her husband from 2016 through 2019.

She then converted the home back into a vacation property and used it as such for 2020 and 2021. Gemma then sells the property on January 1, 2022 for a $540,000 gain. Her total ownership period is nine years (2013-2021).

The first three years of post-2008 use as a vacation home (2013-2015) result in a non-excludable gain of $180,000 (3/9 x $540,000). Gemma must report the $180,000 as long-term capital gain on her 2022 Schedule D. Since she’s eligible for a $500,000 gain exclusion, she can exclude the remaining $360,000 of gain ($540,000 – $180,000).

Key point. The last two years of use of Gemma’s property as a vacation home (2020-2021) don’t count as periods of non-qualified use because they occur:

  1. after the last day of use as a principal residence (December 31, 2019) and
  2. within the five-year period ending on the sale date (January 1, 2022)

Therefore, Gemma’s use of the property as a vacation home in 2020 and 2021 doesn’t make her non- excludable gain any larger.

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Tax Planning Implications of Non-Qualified Use

As you see, the unfavorable rule explained above can take some of the tax-saving fun out of converting a vacation home or rental property into your principal residence.

That said, a reduced gain exclusion is better than no exclusion at all.

In addition, the unfavorable rule is less likely to affect highly appreciated properties (compare the results in Examples 8 and 9). Finally, converting a property into your principal residence sooner rather than later can give you a better tax result, because it minimizes the period of non-qualified use.

 

Takeaways

In a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver.

To claim the maximum gain exclusion of $250,000 or $500,000 for married joint-filers, you must pass the ownership and use tests and avoid the anti-recycling rule.

If you’re affected by the aforementioned restrictions, you may still qualify for a prorated (reduced) gain exclusion under the rules explained in the earlier.

If you are getting married or divorced, make sure you pay attention to the December 31 rule: if you are married on December 31, you are married for the year.

In a divorce, if your ex is going to live in the home for a number of years, make sure your divorce lawyer includes the “living there stipulation” in the divorce papers so that you preserve your $250,000 exclusion.

If in 2009 or later, you converted a vacation home or rental property into your personal residence, make sure to understand the non-qualified use rule and its impact, if any, on your taxable gain from the sale of that residence.

 

1 IRC Section 121.
2 IRC Section 121(d)(1).
3 Reg Section 1 121 -2(a)(3)(ii),
4 Reg Section 1121-2(a)(4), Example 3.
5 IRC Sections 121(a), 121(b); Reg. Section 1.121-2(a).
6 IRC Section 1041(a).
7 Thanks to IRC Section 1041(a).
8 IRC Section 121(d)(3); Reg. Section 1.121-4(b)(1).
9 IRC Sections 121(a); 121(b)(1).
10 Reg Section 1.121-4(b)(2).
11 IRC Section 121(b)(5).
12 IRC Section 121(d)(6).

 

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