The following excerpt is from the current edition of Tax Benefits of Ownership, which gives an overview of the tax exclusions available to a homeowner upon the sale of their past or present principal residence.
Tax-free sale up to $250,000 per homeowner
Consider the sale of a residential property the seller occupies or previously occupied, in whole or in part, as their principal residence. The price is far greater than the price the seller paid for the property, their cost basis in the property.
The cost basis is used to determine the amount of profit — both capital gains and unrecaptured gains — a seller realizes on the sale of a property. An owner’s cost basis comprises:
- the price and transactional costs the seller paid to acquire the property;
- the costs they incurred to renovate and improve the property; and
- any adjustments for depreciation deductions during periods the property was rented to tenants or a portion was dedicated for use as a home office.
The seller’s listing agent is typically proactive about a client’s tax issues on the sale of a property. Being the seller’s principal residence, the agent checks the public records for the number of years the seller has owned the property and whether the seller has a homeowner’s property tax exemption.
The agent establishes:
- the seller has been the vested owner of the property for more than five years;
- the seller has used the property as their principal residence for at least two of the past five years; and
- the public records reflect the seller has a homeowner’s property tax exemption.
As a result, the agent informs the seller that each owner-occupant is qualified to take up to $250,000 in capital gains profit on the sale tax-free due to the principal residence profit exclusion.
Each owner-occupant occupied a portion or all of the property as their principal residence for at least two years during their last five years of ownership. Thus, the $250,000 profit exclusion is available even when:
- the seller originally acquired the property as a rental but has since occupied it;
- the seller having occupied the property now rents the property to tenants;
- the seller has taken depreciation deductions as their home office or rental property; or
- the property consists of two or more residential or mixed-use units. The listing agent also checks out the availability of the §1031 exemption for profits allocated to a home office (business use) or separate rental space (investment property) on the property, or due to the property’s present status solely as a rental. These analyses indicate whether the seller needs to consider the acquisition of another property to avoid the adverse tax impact on the net proceeds from the sale.
The §121 profit exclusion’s array of tax issues
Questions the agent considers when advising on the tax aspects of a sale of property that is or was the seller’s principal residence include:
- On the closing date of the sale, will the property qualify as the owner’s principal residence under the two-out-of-five-year principal residence requirement?
- Who among the co-owners qualifies for up to $250,000 in profit exclusion as an owner and occupant for two out of the five years preceding the close of the sale under the principal residence rule?
- When only one spouse is the vested owner, does the non-vested spouse qualify as an imputed owner by having occupied the property under the principal residence owner-occupant rule?
- Is any homeowner disqualified due to a profit exclusion taken on the sale of a different principal residence which closed escrow within two years before the close of the sale on their current residence?
- When the period of owner-occupancy is less than two years, will the profit on a sale be eligible for a partial exclusion because of personal difficulties which arose:
- prior to completing two full years of ownership and occupancy; or
- within two years after taking a profit exclusion on the sale of a prior principal residence?
What percentage of the profit taken on the sale based on the occupancy-to-ownership ratio qualifies for the $250,000 exclusion?
- Did the homeowner originally acquire their residence as a rental property to replace other property in a §1031 reinvestment plan, then later convert it to their principal residence, triggering a five-year holding period to qualify for the exclusion?
- Has the homeowner depreciated a portion of the residence or the property as their home office or as a rental and if so, will the owner use some or all of the sales proceeds to purchase like-kind §1031 property to avoid reporting unrecaptured gain?
- Is the owner an unmarried surviving spouse who has not owned and occupied the property as a principal residence for the two-year period but can qualify by tacking the deceased spouse’s period of ownership and occupancy to the surviving owner’s?
- Has the owner been placed in a government-licensed facility due to their physical or mental incapacity to care for themselves after residing on the property for a period of at least one of the past five years and thus qualify by tacking the time spent in the facility during their ownership of the property to their actual occupancy to satisfy the principal residency rule?
Occasionally, wealthier couples will have two or three residences they occupy at different times during the year, such as a seasonal or vacation home.
Recall that profit on a sale of any home qualifies for the principal residence profit exclusion when the seller has:
- owned the property for at least five years; and
- occupied the property as their principal residence for at least two years during the five-year period prior to closing the sale.
Factors which identify a property as the owner’s principal residence include its:
- location near the owner’s employment;
- use as the address listed on state and federal tax returns; and
- proximity to banks and professional services used by the owner.
Profit exclusion for one or more owners
The amount of profit taken — realized — as a capital gain on a sale of real estate is set by subtracting the price and transactional costs paid to acquire the property from the net sales price they receive on its sale.
Consider an individual who owns and occupies a property as their principal residence for no more than 23 months before closing a sale of the residence at a profit. No personal difficulties triggered their need to sell the property.
Does the individual qualify for the profit exclusion?
No! The individual did not occupy the property for a total of two of the five years preceding the sale and no personal difficulties existed to shorten the qualifying time.
Exclusion available to a married couple
A married couple owns and occupies a property as their principal residence for at least two of the five years prior to closing a sale of the property. Unless disqualified by other situations, they exclude an aggregate amount of up to $500,000 in profit taken on the sale, i.e., $250,000 per person.
Alternatively, a husband and wife, one of which is the sole owner of a home as separate property, both occupy the property as their principal residence. Here, they jointly qualify for a combined $500,000 profit exclusion on the sale of the residence, when:
- both occupy the property for two years or more within the five-year ownership period prior to the sale;
- the couple files a joint return as a married couple for the year of the sale; and
- neither spouse has taken a profit exclusion on another principal residence within two years prior to the sale.
However, one spouse is individually disqualified when they applied the principal residence profit exclusion to profits on the sale of a residence they sold within the two-years prior to closing the sale of their current residence. Here, the combined exclusion of up to $500,000 is not available. However, when the other spouse separately qualifies for an individual profit exclusion up to $250,000, they may claim the exclusion whether or not they are a vested owner.
For example, the sole owner of a residence held as separate property and their spouse have both occupied the property as their principal residence for more than two of the five years preceding the sale of the residence.
Neither spouse claimed a profit exclusion on the sale of a principal residence which closed escrow within two years prior to closing the sale of their current residence. The couple files a joint return for the year of the sale.
Does each spouse qualify for the combined exclusion allowing the couple to exclude up to $500,000 of profit taken on the sale of the residence solely owned by one spouse?
Yes! The spouse who holds no ownership interest in the residence is classified as an imputed owner. Thus, the couple qualifies for the $500,000 profit exclusion since one spouse owns the residence and both occupied it as their principal residence.
The exclusion’s spousal entanglements with two properties
Consider a husband and wife who each independently owned and occupied separate principal residences during the two-year period immediately prior to their marriage.
On marriage, both the husband and wife vacate their prior residences and relocate to a different residence. Each spouse now needs to sell their prior residence.
The husband sells his prior residence, realizing a profit. The couple files a joint return for the year of the sale.
Does the couple, now married, qualify for the combined exclusion of up to $500,000?
No! Only the husband qualifies to take the individual profit exclusion of up to $250,000 on the couple’s joint tax return. The wife did not need to be a vested owner of the husband’s residence to qualify the couple for the $500,000 profit exclusion. However, the wife was disqualified for failure to occupy the property as a principal residence for two of the five years prior to its sale.
Now consider a situation where the wife closes the sale on her prior residence within two years after the husband closes the sale on his. The husband does not qualify for any part of the exclusion on the wife’s sale. The husband and wife file a joint return for the year the wife’s residence sold, claiming the wife’s $250,000 individual profit exclusion.
Here, the wife qualifies to claim the individual profit exclusion on the couple’s joint return. The husband’s prior claim of an individual $250,000 profit exclusion within two years of the wife’s sale does not disqualify the wife’s claim to the individual exclusion.
In contrast, consider a husband who, either prior to or after getting married, closes escrow on the sale of a solely owned principal residence and realizes a profit.
The husband owned and occupied the principal residence for more than two years during the five years prior to closing the sale. Here, the husband alone qualifies for and claims the profit exclusion on the sale.
Since their marriage, the husband and wife have occupied the wife’s separate property as their principal residence for at least two years during the past five years.
Within two years after the husband closed the sale on which he took a profit exclusion, the residence owned by his wife is sold and escrow closed.
May the couple file a joint return and qualify for the combined profit exclusion of up to $500,000?
No, not both! Only the wife qualifies for an individual profit exclusion of up to $250,000 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 previously took a profit exclusion on the sale of his prior principal residence which closed within the two-year period preceding the closing of the sale of the wife’s residence.
Similarly, had the second residence sold been community property and not separately owned by the wife, only the wife would be allowed to take a profit exclusion on their joint return.
Here, the seller’s agent needs to determine whether the closing of the sale on the residence they both occupied needed to be delayed to a date more than two years after the sale closed on the husband’s residence. Had the close of escrow on the second sale been delayed, the couple would have qualified for the combined profit exclusion.
Residence unoccupied at time of sale
An individual or married couple need not occupy a property as a principal residence when they purchase the property or when they sell it 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 home and moves in, occupying it as their principal residence. The couple rents the old residence to a tenant, converting it into a rental property, and takes their annual depreciation allowance deduction.
Within three years of moving out of their prior residence, the couple closes a sale on the prior residence and takes a profit consisting of both capital gain and unrecaptured gain (depreciation). The couple files a joint tax return for the year of the sale.
Here, the couple may take a $500,000 profit exclusion on the sale even though they did not occupy the property at the time of the sale. The couple owned and occupied the prior residence as their principal residence for at least two of the last five years. However, the amount of recaptured gain due to depreciating the property during the period it was rented is taxed on the sale.
Partial exclusion on a sale due to personal difficulties
At times, individuals or couples sell due to personal difficulties but do not meet the two-out-of-five-year ownership and occupancy requirement needed to claim the full amount of the profit exclusion. When personal difficulties bring about the decision to sell, closing the sale before two years of owner-occupancy, the homeowner qualifies for a prorate share of the $250,000/$500,000 profit exclusion as a partial exclusion.
The partial exclusion allows a homeowner to exclude from taxes all profit on the sale up to a prorated portion of the $250,000/$500,000 profit exclusion. The ceiling amount for partial exclusion is set by a ratio based on the fraction of the two years they were owner-occupants of the residence. Importantly, the proration is not applied to the amount of profit realized on the sale. The ratio is applied only to the total amount of profit excludable — a reduction of the $250,000/$500,000 exclusion ceiling, not a reduction in the profit available for exclusion.
To qualify for a partial exclusion, a change in circumstance due to personal difficulties needs to be the primary reason for sale of the property. Qualifying personal difficulties include:
- a change in employment, based on the seller’s occupancy of the residence at the time of the job relocation and the financial need to relocate for the employment;
- a change in health, such as advanced age-related infirmities, severe allergies, or emotional problems; or
- unforeseen circumstances, such as natural or man-made disasters, death or divorce.
Thus, when a homeowner sells due to personal difficulties, all profit taken on the sale is excluded from taxation up to the ceiling amount of the partial exclusion.
However, when the principal residence is the subject of an exclusion and was acquired as a rental property in a §1031 transaction using §1031 money or in exchange, a five-year holding period exists before the principal residence profit exclusion is available.
The change of circumstances as reasons to sell
Factors used to determine whether the primary reason for the sale is a change in circumstance which qualifies the sale for a partial exclusion include:
- the need compelling the homeowner to relocate and sale of the principal residence both need to occur during the period of occupancy;
- a material change makes the property unsuitable as the principal residence;
- the homeowner’s financial ability to carry the residence requires the residence be sold;
- the need to relocate arose during the occupancy of the residence sold; and
- the need to relocate was not foreseeable by the homeowner when they acquired and first occupied the principal residence sold.
For example, a change in employment may qualify a homeowner for the partial exclusion even when the owner has not owned and occupied their principal residence for the full two-year period.
Employment compelling the homeowner to relocate can be based on:
- a required job relocation by their current employer;
- the commencement of employment with a new employer; or
- the homeowner is self-employed and they relocate of the place of business or commence a new business.
A sale is deemed to be due to a change in employment when:
- the new job location is more than 50 miles farther than the old job from the previous principal residence; or
- the seller was formerly unemployed, and the job location is at least 50 miles from the residence sold.
For example, a homeowner is forced by their employment to relocate out of the area.
The homeowner has owned and occupied their principal residence for one year and six months — 75% of the necessary two-year occupancy period.
The homeowner sells their residence, taking a $40,000 profit.
When filing their tax return, the homeowner is eligible to exclude the entire $40,000 profit from taxation. Here, the entire profit realized is less than the $187,500 partial exclusion (75% of the $250,000 full exclusion). The same ratio applies to a couple’s maximum $500,000 profit exclusion under the same circumstances.
Chronic health issues which compel the homeowner to sell may also qualify the sale for a partial exclusion.
To qualify for health reasons, the owner seeking the exclusion is selling to facilitate the diagnosis, cure, or treatment of an illness or injury, or obtain or provide medical or personal care, for any of the following persons:
- the owner;
- the owner’s spouse;
- a co-owner of the residence;
- a co-occupant residing in the owner’s household as their principal place of abode; or
- close relatives, generally those descended from the owner’s grandparents.
The owner’s sale is also deemed to be due to health reasons when a physician recommends a change of residence.
Unforeseen circumstances may be the primary reasons for the sale of the owner’s principal residence, allowing use of the partial exclusion. Events classified as unforeseen circumstances do not include events the owner could have reasonably anticipated before they owned and occupied the residence.
The mere preference of the owner to own and occupy another property as their principal residence or the financial improvement of the owner permitting acquisition of a more affluent residence does not qualify the sale for the partial profit exclusion.
However, the sale is deemed to be due to unforeseen circumstances when:
- the residence is taken by involuntary conversion; or
- disaster (natural or man-made) or acts of war/terrorism affect the residence.
Further, the homeowner’s sale is deemed to be due to unforeseen circumstances which are experienced by the owner, owner’s spouse, co-owners, co-occupants, who are residents and members of the owner’s household or close relatives, including:
- death;
- loss of employment resulting in unemployment compensation;
- inability to pay housing costs and basic living expenses for the owner’s household;
- divorce or separation by court decree; or
- pregnancy with multiple births.
Owned but not always occupied
An overriding limitation reduces by a percentage the amount of profit to which the exclusion ceiling applies when a property owner does not occupy the property as their principal residence during the entire period of ownership. The profit limitation apples even when the principal residence requirement is met. The result is only a prorate portion of the profit realized on the sale is excluded, while the $250,000/$500,000 exclusion is not altered.
The percentage of the profit that can be excluded on a sale is based on an occupancy-to-ownership ratio covering the entire period of ownership, not just five years.
Periods the owner is considered to have occupied the property as their principal residence include:
- any period of ownership prior to January 1, 2009;25
- any period of use as the owner’s principal residence after January 1, 2009, prior to the sale; and
- any period after terminating their use of the property as a principal residence within five years prior to the sale.
Consider an owner who purchases a property on January 1, 2005, for use as a second home. They begin occupying it as a principal residence on January 1, 2011. They move out on January 1, 2013, terminating their use of the property as their principal residence. The owner closes a sales escrow disposing of the property on January 1, 2015, taking a $300,000 profit.
How much of the $300,000 in profit can the owner exclude under the occupancy-to-ownership ratio since they did not continuously occupy the property during their 10 years of ownership?
On analysis, the owner meets the initial two-out-of-five-year principal residence requirement.
Further, the period of ownership of the property by the seller is ten years.
Of the ten years of ownership, the period of occupancy of the property as the owner’s principal residence is eight years, based on:
- the four years prior to January 1, 2009, even though they did not occupy the property;
- the two years after January 1, 2009, when they actually occupied the property as their principal residence; and
- the two years after terminating their occupancy of the property as their principal residence up to the closing of the sale, even though they did not then occupy the property.
Thus, the occupancy-to-ownership ratio is 8:10, representing the eight years of occupancy over the ten years of ownership.
Here, eight-tenths (80%) of the $300,000 profit on the sale is $240,000, the portion of the profit to which the exclusion is applied. As the exclusion ceiling amount of $250,000 is available to the owner, the occupancy-toownership ratio portion of the profit being less in amount is excludable from the owner’s gross income.
This article reads: “Recall that profit on a sale of any home qualifies for the principal residence profit exclusion when the seller has:
owned the property for at least five years” – this isn’t true. You don’t have to own your home for five years. You have to own it for TWO years. You need to reside in it for at least two of the last five, but you certainly don’t need to own it for five.