This article analyzes the existing and new rules for excluding profits from taxation on the sale of a residential property presently or previously used as the owner’s principal residence.
Tax-free sale up to $250,000 per owner
Consider the seller of a residential property which he currently occupies or previously occupied, in part or in whole, as his principal residence. The price sought is far greater than the seller’s cost basis in the property, which is comprised of:
- the price the seller paid for the property several years ago; and
- the costs incurred to renovate and improve the property.
The seller’s listing agent is interested in the client’s tax aspect of the sale. From information contained in the property profile provided by a title company, he determines the number of years the seller has owned the property and whether the seller has a homeowner’s property tax exemption.
When counseling with the seller, the listing agent further determines the seller has used the property as his principal residence for at least two years during the past five years.
The seller is informed that each owner-occupant is qualified to take up to $250,000 in profit on the sale tax free if each occupied a portion or all of the property as his principal residence for at least two years during his last five years of ownership, whether or not:
- the seller originally acquired the property as a rental but has since occupied it;
- the seller now rents the property to tenants;
- the seller has taken depreciation deductions as his home office (or rental property); or
- the property consists of two or more residential or mixed-use units.
The listing agent agrees to review the tax issues relative to the seller’s qualifying for the principal residence profit exclusion. He also checks out the availability of the §1031 exemption for profits allocated to a home office (business use) or separate rental space (investment property) in or about the residence, or due to the property’s present status solely as a rental.
Questions for the agent to consider when undertaking the duty to advise on the tax aspects of the sale of what is or was the seller’s principal residence include:
- At the time of the sale, does the property qualify as the owner’s principal residence under the two-out-of-five-year principal residence rule? [Internal Revenue Code §121(a)]
- Who among the co-owners qualifies for the up to $250,000 profit exclusion as an owner and occupant for periods totaling two years during the five years preceding the close of the sale under the principal residence rule? [IRC §121(a)]
- If only one spouse is the vested owner, does the non-vested spouse qualify as an owner by having occupied the property under the principal residence rule? [IRC §§121(b)(2), 121(d)(1)]
- Is the homeowner disqualified for having taken a profit exclusion on the sale of a different principal residence which closed escrow within two years before the close of the sale on his current residence? [IRC §121(b)(3)]
- If the period of owner-occupancy is less than two years, will the sale of the property be eligible for a partial exclusion as a result 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? [IRC §§121(c)(1), 121(c)(2)]
- What percentage of the profit taken on the sale, based on the occupancy-to-ownership ratio, can be excluded from taxation, limited to the $250,000 per person ceiling?
- Did the homeowner originally acquire his residence as a rental property to replace other property he sold (or exchanged) in a §1031 reinvestment plan, and later convert it to his principal residence, triggering a five-year holding period that must pass before the principal residence profit exclusion is allowed? [IRC §121(d)(10)]
- Does the homeowner presently depreciate a portion of the residence or the property as his home office or as a rental (duplex, etc.) and is the owner considering using some or all of the net sales proceeds to purchase like-kind §1031 property?
- Did the homeowner take any depreciation deductions for his use of the property as his office or a rental after May 6, 1997 which must be reported as unrecaptured gain (25% tax), unless avoided by acquiring a replacement home office or rental in a §1031 reinvestment plan? [IRC §121(d)(6)]
- Is the owner an unmarried surviving spouse who has not owned and occupied the property as a principal residence for the two-year period who can still qualify by tacking the deceased spouse’s period of ownership and occupancy to the surviving owner’s? [IRC §121(d)(2)]
- If the owner is now in a government-licensed facility due to his physical or mental incapacity to care for himself and previously resided on the property for periods totaling at least one year during the past five years, does he qualify by tacking the time spent in the facility during his ownership of the property to satisfy the principal residency rule? [IRC §121(d)(7)]
Principal 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.).
To qualify a property for the principal residence profit exclusion, the property must be owned and occupied as the owner’s principal residence for at least two years during the five-year period prior to closing the sale. [IRC §§121(a), 121(b)(1)]
- 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 sole owners 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 net sales price he receives — a formula of “price minus basis equals profit.” Up to $250,000 if profit taken by an individual on the sale of his principal residence may qualify for the profit exclusion.
Each individual who owns a property, solely or with others, and who owned and occupied it as a principal residence for periods totaling two of the five years immediately preceding closing the sale, is eligible to exclude up to $250,000 of his profit on its sale.
Consider an individual who owns and occupies a property as his principal residence for no more than 23 months before closing a sale of the residence at a profit. No personal difficulties triggered his 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 years within the five-year period immediately preceding the sale, and no personal difficulties shortened the qualifying time. The time period limitation for ownership and occupancy must be met to exclude the profit from taxes. [IRC §121(a)]
Exclusion available to a married couple
A married couple own and occupy 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 events, they may exclude an aggregate amount of up to $500,000 in profit taken on the sale, i.e., $250,000 per person. [IRC §121(b)(2)(A)]
Alternatively, a husband and wife who do not both own and occupy a property as their principal residence may jointly qualify for up to a combined $500,000 profit exclusion on the sale of their principal residence, if:
- either the husband or the wife solely owns the residence as separate property (or they are co-owners) since sole ownership by one spouse is imputed to the non-owner spouse;
- both occupy the property during the ownership for time periods totaling two years or more within the five-year 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. [IRC §121(b)(2)]
However, one spouse might be individually disqualified for having taken the principal residence profit exclusion on the sale of another residence which closed within the two-year period prior to closing the sale of the current residence. In this case, the combined exclusion of up to $500,000 is not available. However, the other spouse may separately qualify for an individual profit exclusion up to $250,000, whether or not he is a vested owner. [IRC §121(b)(2)(B)]
For example, a husband is the sole owner of a residence as his separate property. The husband and his wife both occupy the property as their principal residence during his ownership. They do so for a total of more than two years during the five years immediately preceding their sale of the property.
Neither spouse is disqualified for having taken a profit exclusion on the sale of a principal residence which closed escrow during the two-year period prior to closing. 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 an imputed owner. Thus, the couple is qualified for the profit exclusion since one spouse owns the property. Both, as required, occupied for the minimum two years within the five-year period prior to closing the sale.
No disqualifying marital taint
Consider a husband and wife who each independently owned and occupied separate principal residences for two years prior to their marriage.
On marriage, both the husband and wife vacate their prior residences and relocate to an entirely different property as their residence. Each spouse now needs to sell their prior residence.
The husband sells his prior residence at 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. While the wife did not need to be a vested owner of the husband’s residence, she did have to occupy the property as her principal residence for two of the five years prior to his sale of the property to qualify the couple for the combined $500,000.
Further, and 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 residence for two of the past five years, qualifies for an individual profit exclusion of up to $250,000. The husband and wife file a joint return for the year the wife sold her residence and claim the wife’s individual profit exclusion.
Here, the wife is qualified to take the individual profit exclusion on the couple’s joint return — even though the husband sold and took a 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. The profit exclusion is qualified for and taken on the sale.
Since his 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 a profit exclusion, the residence owned by his wife is sold and escrow closed.
Can the couple file a joint return and qualify for the combined profit exclusion of up to $500,000 by reason of their marriage, the wife’s separate ownership, and their shared occupancy of the residence?
No! 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. Thus, the couple does not qualify for the combined profit exclusion of up to $500,000. [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 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 close of escrow on the second sale had been delayed, the couple would have qualified for the combined profit exclusion.
Personal difficulties compel the sale
Even if an individual or couple cannot fully meet the two-year ownership and occupancy requirements, they may still qualify to exclude all (or a portion) of their profit under a partial exclusion available to owners who sell due to personal difficulties.
The partial exclusion is a prorated portion of the profit exclusion, not a pro rata portion of the profit taken on the sale. The proration sets the maximum dollar amount of the partial exclusion available to cover any profits. The ratio applied to the exclusion to set the amount of the profit to be excluded is based on the fraction of the two years they have occupied the property.
To qualify for a partial exclusion, a personal difficulty must arise and be the primary reason for sale of the property, which includes:
- a change in employment, based on 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, and divorce. [IRC §121(c)(2)(B); Revenue Regulations §1.121-3]
Thus, when a homeowner must sell because of personal difficulties, all profit is excluded from taxation up to the ceiling amount of the partial exclusion set by that fraction of two years the owner actually owned and occupied the property as his principal residence. [IRC §121(c)(1)]
However, if the principal residence for which the owner seeks a partial exclusion was a rental acquired as a replacement property to complete a §1031 transaction using §1031 money or in exchange, the five-year holding period applies and must run before the §121 residential profit exclusion is available.
Factors used to determine whether the primary reason for the sale is a change in circumstances which qualifies the sale for a partial exclusion include:
- the sale of the principal residence and the need compelling the homeowner to relocate are close in time;
- 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 he acquired and first occupied the principal residence sold. [Rev. Regs §1.121-3(b)]
For example, a change in employment may qualify the homeowner for the partial exclusion without first owning and occupying his principal residence for the full two-year period.
Employment compelling the homeowner to relocate can be based on a required job relocation by his current employer, the commencement of employment with a new employer, or if the homeowner is self-employed, the relocation of the place of business or the commencement of a new business.
A sale is deemed to be by reason of a change in employment if:
- the new job location is more than 50 miles farther than the old job was from the principal residence that was sold; or
- if the seller was formerly unemployed, the job location is at least 50 miles from the residence sold. [Rev. Regs. §1.121-3(c)]
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 is eligible to exclude the entire $40,000 profit from taxation since the entire profit is less than the $187,500 partial exclusion (75% of the $250,000 full exclusion). The same ratio would apply to a couple’s maximum $500,000 profit exclusion under the same circumstances. [IRC §121(c)]
Health issues of a chronic nature, which compel the homeowner to sell may qualify the sale for partial exclusion.
To qualify for reasons of health, the owner seeking the exclusion must need to sell in order to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of a disease, illness or injury, or obtain and provide medical or personal care, for any of the following persons:
- the owner himself;
- the owner’s spouse;
- a co-owner of the residence;
- a co-occupant residing in the owner’s household as his principal place of abode; or
- close relatives, generally those descendent of the owner’s grandparents.
The owner’s sale is also deemed to be due to health reasons if a physician recommends a change of residence (relocation). [Rev. Regs. §1.121-3(d)]
Unforeseen circumstances may arise and provide the primary reasons for the sale of the owner’s principal residence, permitting use of the partial §121 exclusion of profit from taxation. Events which occur and are classified as unforeseen circumstances do not include events which could have been reasonably anticipated by the owner before he owned and occupied the residence.
Also, the mere preference of the owner to buy another property to own and occupy as his principal residence or the financial improvement of the owner permitting acquisition of another more affluent appearing residence does not qualify the sale for the partial §121 exclusion of profit.
However, the owner’s sale is deemed to be due to unforeseen circumstances if:
- the residence is taken by an involuntary conversion; or
- disaster (natural or man-made) or acts of war/terrorism cause a casualty loss to the residence.
Further, the homeowner’s sale is deemed to be due to unforeseen circumstances if the following events occur to the owner, owner’s spouse, co-owners, co-occupants who are residents and members of the owner’s household and close relatives:
- 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
- a pregnancy with multiple births. [Rev. Regs. §1.121-3(e)]
Percentage limitation on profit excluded
Once the sale of a property qualifies for a profit exclusion by being owned and occupied as a principal residence for at least two years out of the five-year period prior to the sale of the property, the percentage of the profit that can be excluded from taxation must be determined.
The percentage of the profit 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 his principal residence include:
- any period of ownership prior to January 1, 2009 [IRC §121(b)(4)[(5)](C)];
- any period of use as the owner’s principal residence after January 1, 2009 prior to the sale; and
- any period after terminating his use of the property as a principal residence within the five years prior to the sale. [IRC §121(b)(4)[(5)](C)(ii)]
Consider an owner who purchases a property on January 1, 2005 for use as a second home. He first occupies it as his principal residence on January 1, 2011. He later moves out on January 1, 2013, terminating the property’s use as his principal residence. The property is then sold, closing escrow on January 1, 2015, taking a $300,000 profit.
The issue is now, “how much of the $300,000 in profit can the owner exclude since he did not occupy the property at all times during his ownership?”
In analysis, the owner meets the initial two-out-of-five-year principal residence requirement.
The seller’s period of ownership of the property is ten years.
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 he did not occupy the property himself;
- the two years after January 1, 2009 when he actually occupied the property as his principal residence; and
- the two years after terminating his occupancy of the property as his principal residence up to the closing of the sale.
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. That amount of the profit is excludable from the owner’s gross income since it does not exceed the ceiling amount of the $250,000 principal residence exclusion. [IRC §121(b)]
An orderly liquidation and §1031
Now consider a married couple who have, for the past two years, owned and occupied a home as their principal residence. They also own, either separately or as community property, several single-family residential rental properties.
The couple vacate their principal residence on December 31, 2011 when they close escrow on a sale of the property and take a profit. They file a joint tax return for the year of the sale and qualify for the combined profit exclusion.
The couple then move into another residential property they have owned since 2003, converting that property from a residential rental property into their principal residence.
On December 31, 2013, two years after occupying the second property as their principal residence, the couple close escrow on the sale of the property and take a profit. The couple file a joint tax return for the year of sale and claim the profit exclusion of up to $500,000 to avoid taxes on the profit since they qualify under the two-out-of-five-year principal residence rule.
However, the occupancy-to-ownership ratio for setting the percentage of the profit which is excludable must be established and applied to the profit they have taken.
The coupled had owned the second property at the time of sale for ten years (from 2003-2013). They occupied it as their principal residence for two years immediately prior to closing the sale. Here, eight years of the ten-year period of ownership is considered occupied, an occupancy-to-ownership ratio of 8:10 — six years pre-2009 and two years post-2008.
The years after 2008 before the property became the owner’s principal residence limits the profit available for exclusion.
Thus, by repeating the two-year occupancy of single-family residences they own as their principal residence under either of the above scenarios, the couple is able to:
- liquidate their real estate holdings; and
- avoid paying tax on much of 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 exclusion of profit on the sale.
However, if any property now occupied as the principal residence was acquired as a rental in a §1031 reinvestment plan and later converted into the principal residence of the owner, a holding period of five years must run before the owner may sell and qualify for the §121 residential exclusion. However, the two-year period for principal residency remains unchanged. [IRC §121(d)(10)]
For example, an individual or couple acquires a residence for business or investment property purposes as replacement property in a §1031 reinvestment plan. Later, the property is converted into their principal residence for the necessary two years.
Here, they must retain ownership of the residence for at least five years after acquiring it before a sale of the property will qualify for the profit exclusion available to each owner.
Occasionally, the homeowner will establish a home office within the residence or in a space separate from the residence, such as a granny flat, maids’ quarters, or other rentable space on the same parcel as the residence. The home office area is allocated its pro rata share of the cost basis, and depreciation deductions are reported.
On a sale of the property, the §121 profit exclusion is always applied first to the profit taken on the residential portion of the cost basis in the property, that portion of the profit and basis not allocated to the depreciable portion used as the home office.
If the home office is within the space of the residence, not separate from the residence in other quarters, the §121 profit exclusion applies to the home office space as well, called a spillover, except for the depreciation taken on the home office space. Not so for the home office located in space separate from the residence. Either way, the depreciation portion of the profit is taxed at the 25% maximum unrecaptured gain rate.
Also, the depreciable portion of the property used as the home office (or a separate rental) at the time of sale is §1031 property, entitled to have its pro rata share of net sales proceeds reinvested in other property to complete a §1031 plan. [Rev. Proc. 2005-14]