(This is Part 1 of an eight-part series. See Part 2, Part 3, Part 4, Part 5, Part 6, Part 7 and Part 8.)
It’s difficult for most of us to get very excited about income taxes. But when it comes to earning up to $250,000 tax-free (up to $500,000 for a qualified married couple), have I got your attention yet?
EASY QUALIFICATIONS FOR THIS TAX BREAK. Of course I’m referring to the Internal Revenue Code 121 principal residence sale tax exemption. To qualify, you must have owned and occupied your primary home at least 24 of the 60 months before its sale.
Only one spouse’s name need be on the title but each spouse can qualify for up to $250,000 ($500,000 total) tax-free profits if both meet the 24-month occupancy test and file a joint tax return in the year of sale.
The method of holding title doesn’t matter even if title is held in a living trust. Of course, if two individuals not married to each other both hold title and each owns and occupies the principal residence at least 24 of the 60 months before its sale, then each co-owner qualifies for up to $250,000 tax-free capital gains.
If you are in the military or Foreign Service, special rules apply and your 24-month home occupancy can be as far back as 15 years from the date of sale.
Your 24-month principal residence occupancy need not be continuous. However, if you bought and occupied your primary home as recently as 24 months ago before selling it, you meet the 24 out of the last 60-month ownership and occupancy test.
Watch out if you acquired your home in an Internal Revenue Code 1031 tax-deferred exchange. The reason is for such home sales after October 22, 2004 you must have owned the property at least 60 months although you only need 24 months of principal residence occupancy during that time.
The property need not be your principal residence on the date of sale. For example, if you occupied your home for at least 24 months during the 60 months before sale, you could rent the house to tenants as long as 36 months before losing your entitlement.
Home sellers of any age can qualify. There is no need to buy a replacement principal residence. This generous tax break can be used over and over without limit. However, it cannot be used more frequently than once every 24 months.
WHERE IS YOUR PRINCIPAL RESIDENCE? If you own and personally use more than one home, such as a Florida winter home and a summer Michigan home, this tax break only applies when you sell your “main home” as the IRS calls it. Occupancy time alone doesn’t determine your principal residence.
For example, in the tax case of Guinan v. U.S. (2003-1 USTC 50475) the Guinans sold their Green Bay, Wis., home where they spent more time than at their other homes. Although they met the 24 out of last 60-month occupancy test, and kept a bank account and automobile in Wisconsin, the U.S. District Court said it wasn’t their primary residence because the Guinans never filed their income tax returns from Wisconsin. The sad tax result for them was paying a $45,009 capital gain tax on the sale.
In addition to meeting the occupancy test, the IRS says principal residence indicators (when you own more than one home) include (1) place of employment; (2) principal place of abode for the taxpayer’s family members; (3) address on taxpayer’s federal and state tax returns; (4) location of taxpayer’s banks; (5) location of automobile and driver’s license registrations; and (6) civic affiliations, such as taxpayer’s religious organizations and recreational clubs.
CONFUSION ABOUT SALE OF HOME IN YEAR OF SPOUSE’S DEATH. When a principal residence is sold in the year of a spouse’s death, IRC 121(b)(2) permits full use of the tax exemption up to $500,000, if qualified. The tax reason is a surviving spouse can file a joint tax return with the deceased spouse in the tax year of that death but not in future tax years.
However, surviving spouses should not rush to sell their principal residence within the same year as the spouse’s death. The reason is when the surviving spouse inherits the deceased spouse’s share of the home, the surviving spouse receives a new “stepped-up basis” for at least 50 percent of the home’s market value on the date of death. In community property states, the surviving spouse usually receives a new 100 percent stepped-up basis to market value.
LITTLE KNOWN TAX BREAK FOR DIVORCED AND SEPARATED HOME SELLERS. Most divorced and separated couples are not aware they can still qualify for up to $500,000 total tax-free principal residence sale profits. In a little-known provision of IRC 121, if one divorced or separated spouse (called the “in spouse”) qualifies for the $250,000 tax break by owning and living in the residence at least 24 months, the other spouse (called the “out spouse”) can also qualify for up to $250,000 tax-free profits when the home is sold.
This tax break is frequently used when one spouse stays in the home until the children become 18 or 21 and the home is sold. Even the non-resident co-owner ex-spouse can then qualify for up to $250,000 tax-free home sale profits.
SALE OF ADJOINING VACANT LAND CAN ALSO QUALIFY. Another little-known provision in IRC 121 permits the sale of an adjoining vacant lot to qualify for the exemption. However, this special tax benefit is only available if the adjacent principal residence is sold within 24 months before or after the lot sale.
PARTIAL EXEMPTION IF YOU DON’T MEET THE 24-MONTH OCCUPANCY TEST. Even if you don’t fully meet the 24-month occupancy test within the last 60 months before the principal residence sale, you may qualify for a partial exemption. Acceptable reasons for the home sale include (1) change of employment location qualifying for the moving cost tax deduction; (2) health reasons; and (3) unforeseen circumstances.
The change of work location and health reasons exceptions haven’t caused problems. But “unforeseen circumstances” are more difficult as acceptable reasons are still evolving.
The IRS says these reasons are acceptable: (1) divorce or legal separation; (2) death in the immediate family; (3) unemployment; (4) decreased income leaving the taxpayer unable to pay the mortgage or basic living expenses; (5) multiple births from the same pregnancy; (6) damage to the home from a natural or man-made disaster or terrorism; and (7) condemnation, seizure or other involuntary conversion of the property.
If you meet the partial exemption test with one of the above reasons for the home sale, a percentage of your $250,000 or $500,000 exemption is available.
For example, suppose you owned and occupied your primary residence for 12 months before you moved due to a qualifying change of employment location. You would therefore be entitled to a partial exemption of 12/24 or 50 percent of $250,000 or $500,000.
HOW TO AVOID TAX ON MORE THAN $250,000 OR $500,000 HOME SALE CAPITAL GAIN. Thanks to large recent increases in market values, many home sellers have the nice problem that their home sale capital gains exceed the IRC 121 tax exemptions. The only way to make a fully tax-exempt property sale in that situation is to make an Internal Revenue Code 1031 tax-deferred exchange.
To do this, the home seller must (1) move out of their home and rent it to tenants (most tax advisers suggest at least six to 12 months); (2) then sell your former home rental property, and (3) use the sales proceeds to acquire another rental or investment property of equal or greater cost and equity.
Be sure to comply with IRC 1031(a)(3) (known as a Starker exchange) which requires designating the replacement property within 45 days after the sale and taking title within 180 days. Meanwhile, the sales proceeds must be held by a qualified intermediary exchange accommodator beyond the trader’s “constructive receipt.”
CONCLUSION. Internal Revenue Code is a very generous tax exemption allowing principal residence sellers to earn up to $250,000 (up to $500,000 for a married couple) tax-free every 24 months. But the easy qualification rules must be followed. For full details, please consult your tax adviser.
NEXT WEEK: Maximize Your Second Home Tax Savings.
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