SELLING A PRINCIPAL RESIDENCE

With residential real estate markets booming, many homeowners are piling up significant unrealized gains. That’s good news for those who are ready to sell, but there are tax implications. Thankfully, the Section 121 federal income tax gain exclusion break for principal residence sales is still on the books, and it’s a potentially big tax-saving deal for sellers.

For a married couple filing a joint return, the exclusion can shelter up to $500,000 of gain from federal income tax. For all other homeowners, the exclusion can shelter up to $250,000 of home sale gain. No special tax form is required to take advantage on the gain exclusion. Report the taxable part (if any) of a principal residence gain on Schedule D of Form 1040. The current maximum individual federal rate for long-term capital gains is 20% (23.8% if the 3.8% net investment income tax applies). This assumes no retroactive rate increase on capital gains recognized in 2021.

If part of the client’s gain is taxable due to business or rental use of the home, Form 4797 (Sales of Business Property) must be included with the Form 1040 for the year of sale. Form 4797 is used to calculate how much of the gain is subject to the 25% maximum capital gains tax rate on gain attributable to depreciation deductions (so-called unrecaptured Section 1250 gain).

Ownership and Use Tests. To take full advantage of the Section 121 principal residence gain exclusion, the taxpayer must pass two tests:

(1.) The Ownership Test. The home must have been owned for at least two years during the five-year period ending on the sale date.

(2.) The Use Test. The home must have been used as a principal residence for at least two years during the five-year period ending on the sale date.

Note: These two tests are independent. Therefore, periods of ownership and use need not overlap. For both tests, two years means periods aggregating to 24 months or 730 days.

Definition of Principal Residence. All facts and circumstances must be considered to determine whether a home is the client’s principal residence for the home sale gain exclusion. If the client occupies several residences during the same tax year, generally the principal residence for that year is the one where the client spent the majority of time. But other relevant factors can include:

• Where the client works.

• Where family members live.

• The address shown on the client’s income tax returns, driver’s license, and auto registration and voter registration cards.

• The client’s mailing address for bills and correspondence.

• Where the client maintains bank accounts.

• Where the client maintains memberships and religious affiliations.

Example 1: Sandor is unmarried and owns one home in Maryland and another in Colorado. During 2017-2021, he spends seven months each year in the Maryland home and the remaining five months in the Colorado home. He sells both properties on 12/31/21. Barring unusual circumstances, the Maryland home is Sandor’s principal residence, so he can only exclude the gain for that property. Even though he owned and used the Colorado home as a residence for a total of 25 months during the five-year period ending on the sale date, Sandor cannot claim the gain exclusion for that property because it was not his principal residence at any time during the five-year period.

Example 2: Tawny is unmarried. She owns one home in Michigan and another in Florida. In 2017 and 2018, she lived in the Michigan home. In 2019 and 2020, she lived in the Florida home. In 2021, she once again lives in the Michigan home. Tawny qualifies for the gain exclusion if she sells either home in 2021, because she meets the ownership and use tests for both homes. However, if she sells both homes in 2021, she can only claim the exclusion for one of the sales. See the anti-recycling rule explained later.

Special Considerations for Married Homeowners

Married taxpayers who file separately can potentially qualify for two separate $250,000 exclusions.

Example 3: Victor and Vickie have jointly owned a greatly-appreciated home for years and have used it as their principal residence for years. They file separate federal income tax returns. That precludes eligibility for the $500,000 joint-filer Section 121 gain exclusion. However, Victor and Vickie qualify for separate $250,000 exclusions because they both pass the ownership and use tests. If the gain on their home sale is at least $500,000 Victor can exclude $250,000 of his gain and Vickie can do the same. So, they can exclude up to a combined $500,000.

A married joint-filing couple qualifies for the $500,000 exclusion only if: (1) either spouse passes the ownership test for the property and (2) both spouses pass the use test.

Example 4: Ward and Wendy get married after a whirlwind romance. Immediately following their marriage, Ward 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 Wendy. They file a joint return for the year of sale. Unfortunately, they don’t qualify for the larger $500,000 joint-filer exclusion because Wendy does not pass the use test for the property. Therefore, the couple must report a $350,000 taxable gain on their joint Form 1040 ($600,000 – $250,000). Ouch! This is the kind of thing that can happen when folks fail to talk to their tax pros before making major transactions.

Variation: Instead of selling immediately, the couple could have lived together in Ward’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 Ward would have passed the ownership test and both Ward and Wendy would have passed the use test.

When a married couple files jointly, it’s possible for each spouse to pass the ownership and use tests for a separate residence. In that case, the couple would qualify for two separate $250,000 exclusions. Each spouse’s eligibility for the $250,000 exclusion is determined separately, but a spouse is considered to individually own a property for any period the property is actually owned by either spouse.

Example 5: Zoey and Zed file jointly. Zoey works in Dallas and lives most of the time in the couple’s jointly-owned home there. Zed works in Santa Fe and lives most of the time in their jointly-owned townhouse there. Sometimes, one spouse travels to the other’s city, and they both stay in their home there. The $500,000 joint-filer exclusion is not available for either home, because both spouses must pass the use test to qualify for the larger exclusion. But separate $250,000 exclusions are potentially available for each residence. Assume the couple has jointly owned both homes for five years and that Zoey passes the use test for the Dallas home while Zed passes the use test for the Santa Fe home. Zoey would qualify for a $250,000 exclusion if the Dallas home is sold and Zed would qualify for a separate $250,000 exclusion if the Santa Fe home is sold. 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.

Variation: As long as they file joint returns, the results would be the same even if Zed separately owns the Dallas home and Zoey separately owns the Santa Fe home. That’s because under the rules for joint filers, Zed is considered to own any home actually owned by Zoey, and Zoey is considered to own any home actually owned by Zed. So, Zoey would still pass the ownership and use tests for the Dallas home even though she doesn’t own any part of it and Zed would still pass the ownership and use tests for the Santa Fe home even though he doesn’t own any part of it.

Special Rule for Unmarried Surviving Spouses. While a couple filing a joint return can exclude up to $500,000 of a principle home sale gain, a surviving spouse cannot file a joint return for years after the year the other spouse died (unless the surviving spouse remarries). So, surviving spouse would be precluded from taking advantage of the $500,000 exclusion for a home owned with their deceased spouse if the home is not sold by the end of the year the spouse died. Thankfully, an unmarried surviving spouse can claim the $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.

Note: 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.

The Anti-recycling Rule

The other big qualification rule for the home sale gain exclusion goes like this: the exclusion is generally available only when no exclusion was claimed for an earlier principal residence sale within the two-year period ending on the date of the later sale. The $500,000 joint-filer exclusion can only be claimed if both the taxpayer and the spouse did not exclude a home sale gain for an earlier sale within the two-year period. 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 in this release assume that your client is unaffected by the anti-recycling rule. If the client is affected, no gain exclusion is allowed unless-

(1.) the client is eligible for a prorated gain exclusion, or

(2.) the client elects out of the gain exclusion for the earlier sale, as explained below.

Example 6: Azalea is unmarried. She sold her principal residence on 7/1/20 and excluded $250,000 of gain. Before selling that home, she purchased another property on 1/1/20 (six months earlier) and began using it as her new principal residence. On 3/1/22, Azalea sells the home she purchased on 1/1/20, thinking she will qualify for another gain exclusion because she owned the home and used it as her principal residence for more than two years. Oops! While she passes the two-out-of-five-years ownership and use tests with flying colors, Azalea is an unsuspecting victim of the anti-recycling rule. So, she cannot exclude any gain from the 2022 sale, unless one of the two circumstances listed immediately above applies.

When Electing Out of the Gain Exclusion Can Pay Off

A home seller can elect out of the gain exclusion. The election out is made by reporting an otherwise excludable gain on Schedule D of Form 1040 for the year of sale. No further action is required. Note that the taxpayer can retroactively elect out or revoke an earlier election out by filing an amended return within the three-year period beginning with the unextended due date for the year-of-sale return.

The most obvious situation when electing out can be beneficial is when the client has two principal residence sales within a two-year period, with the later sale producing a larger gain.

Example 7: Ben and Betty are married joint filers. They jointly own homes in Kansas City and Aspen. They use the Kansas City home as their principal residence in 2017 and 2018 and the Aspen home as their principal residence in 2019 and 2020. In early 2021, they sell the Kansas City property for a $150,000 gain. In early 2022, they sell the Aspen property for a $950,000 gain. Ben and Betty pass the two-out-of-five-years ownership and use tests for both properties. Assume they exclude the gain on their Kansas City home sale. Because the Aspen property was sold less than two years after the Kansas City home was sold, the couple cannot claim the gain exclusion for the Aspen sale. Here, the couple should elect out of the gain exclusion for the Kansas City sale so that they can exclude $500,000 of gain from the later and much-more-profitable Aspen sale.

In conclusion, in a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion can be a major tax-saver. Sellers 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-filing couples. Sellers who are affected by these restrictions might qualify for a prorated (reduced) gain exclusion.