CCH-EXP, 2000FED ¶7266.01, Exclusion of Gain on Sale of Residence: Synopsis - exclusion of gain on sale of principal residence.--

Exclusion of Gain on Sale of Residence: Synopsis - exclusion of gain on sale of principal residence.--------------------------

The Taxpayer Relief Act of 1997 (P.L. 105-34) fundamentally changed the treatment of gain on the sale of a residence. The Act replaced the provision allowing rollover of gain (repealing former Code Sec. 1034 ) and the one-time exclusion of $125,000 of gain for taxpayers over age 55 (former Code Sec. 121 ), with a relatively simple $500,000 gain exclusion (Code Sec. 121 , as amended by P.L. 105-34). The effect of the old rules was to force a home seller to purchase continually more expensive homes to take advantage of the rollover provision. The rollover provision was unavailable when the objective was to downsize or rent, and the one-time $125,000 exclusion for taxpayers age 55 or over provided only limited relief and many traps for the unwary. In contrast, the new law provides an exclusion--not a deferral. This gives homeowners greater flexibility in arranging their affairs without having to make home buying decisions based primarily on tax considerations.

Under the amended Code Sec. 121 , an individual may exclude from income up to $250,000 of gain realized on the sale or exchange of a residence. The exclusion increases to $500,000 for joint filers. A taxpayer may elect out of the provision.

The exclusion (and repeal of the rollover provisions and one-time $125,000 exclusion; see ¶7266.022 ) applies to sales and exchanges after May 6, 1997. Taxpayers may elect to apply prior law (see ¶7266.022  et seq.) to sales or exchanges (1) made on or before August 5, 1997, (2) made after August 5, 1997, pursuant to a binding contract in effect on August 5, 1997, or (3) when the replacement residence was acquired on or before August 5, 1997, and the rollover provision would apply (Act Sec. 312, (P.L. 105-34), as amended by the IRS Restructuring and Reform Act of 1998 (P.L. 105-206)). Such an election is not available to expatriates subject to Code Sec. 877(a)(1) .

The Taxpayer Relief Act of 1997 (P.L. 105-34) did not wipe the slate clean of accumulated deferred rollover gains. Therefore, taxpayers may face an unexpected capital gains tax on the sale of their next principal residence--a tax they would not likely have faced under the old rules. A home seller with gains in excess of the exclusion may prefer to use the old law to roll the gain over into a new house.

Frequency of sales or exchanges limited. The exclusion applies to only one sale or exchange every two years, but pre-May 7, 1997 sales are not taken into account (Code Sec. 121(b)(3) ).

Ownership and use. The individual must have owned and occupied the residence as a principal residence for an aggregate of at least two of the five years before the sale or exchange.

The required two years of ownership and use need not be continuous. The test is met if taxpayer owned and used the property as a principal residence for a total of 730 days (365 x 2) during the five-year period before the sale. Short temporary absences for vacations or seasonal absences are counted as periods of use, even if the taxpayer rents out the property during those periods (IRS Publication 17, “Your Federal Income Tax,” p. 109 (for 1998 returns). However, an absence of an entire year is not considered a short temporary absence (IRS Publication 523, “Selling Your Home,” (for 1998 returns)).

The ownership and use tests may be met at different times (i.e., during different two-year periods), provided that both tests are met during the five-year period before the date of sale.

The law does not require that the home sold have been the principal residence at the time of purchase or sale--only that the taxpayer’s use of the home as a principal residence total two years or more within the five-year period ending on the date of sale. For example, taxpayers could move into their vacation home, converting it into their new principal residence, while having up to three more years to sell their old principal residence to take advantage of the exclusion.

Married individuals. The amount of excludable gain increases to $500,000 for married individuals filing jointly if:

(1) either spouse meets the ownership test,

(2) both spouses meet the use test, and

(3) neither spouse is ineligible for exclusion by virtue of a sale or exchange of a residence within the last two years (Code Sec. 121(b)(2)(A) ).

If spouses do not meet all three requirements, the exclusion is determined on an individual basis and equals the sum of the exclusion limitations to which each spouse would have been entitled had they not been married (Code Sec. 121(b)(2)(B) ). Each spouse is treated as owning the property during the period that either spouse owned the property. Thus, for married couples who do not share a principal residence but file joint returns, a $250,000 exclusion is available for a qualifying sale or exchange of each spouse’s principal residence. Also, if a single individual eligible for the exclusion marries someone who has used the exclusion within two years before the marriage, the individual is entitled to a $250,000 exclusion. In other words, the fact that the individual’s spouse used the exclusion within the past two years does not prevent the individual from claiming the exclusion (solving the “tainted spouse” problem that arose under prior law; see ¶7266.027 ).

Example (1): Susan and Craig Hart married in April 1999 and will file a joint return. Before they married, each owned a condominium that each used separately as a principal residence for over two years. The condominiums were finally sold at a gain in June 1999. The $500,000 exclusion for married taxpayers filing jointly does not apply because Susan and Craig did not use the same condominium as their joint principal residence for the required two-year period. However, they are each entitled to exclude up to $250,000 of gain on the sale of each of their separate condominiums, that is, the exclusion that each would have been entitled to had they not married.

Example (2): Assume the same facts as in Example (1), above, except that Susan lived in her parents’ home prior to marriage instead of in her own condominium. In this case, the $500,000 exclusion is not available with respect to Craig’s condominium because the joint use test is not satisfied. However, since Craig would have been entitled to a $250,000 exclusion if he had not been married, Craig and Susan may exclude up to $250,000 of the gain from the sale of his condominium on their joint return.

The provision limiting the exclusion to only one sale every two years by the individual does not prevent a husband and wife from filing a joint tax return and each excluding up to $250,000 of gain from the sale of each spouse’s principal residence (Code Sec. 121(b)(2) ). This rule applies if each spouse would have been permitted to exclude up to $250,000 of gain if they had filed separate tax returns (see ¶7260.025 ).

Gain recognized to extent of depreciation. The exclusion does not apply, and gain is recognized, to the extent of any depreciation allowable with respect to the rental or business use of a principal residence after May 6, 1997 (Code Sec. 121(d)(6) ).

Exclusion prorated. The $250,000 or $500,000 exclusion (not the realized gain) is prorated if a taxpayer does not meet the two-year ownership and use requirements in the case of a sale or exchange due to a change in the place of employment, health or unforeseen circumstances (Code Sec. 121(c)(1) ). In such cases, the amount of the available exclusion is equal to the amount of the applicable exclusion ($250,000 or $500,000) multiplied by the ratio of:

(1) the shorter of (a) the aggregate periods during which the ownership and use requirements were met during the five-year period ending on the date of sale or (b) the period after the date of the most recent sale or exchange to which the exclusion applied, over

(2) two years.

The circumstances under which the exclusion may be prorated due to a sale or exchange involving unforeseen circumstances is to be determined by IRS regulations (Code Sec. 121(c) ).

Example (3): On September 1, 1998, Al and Lisa Jackson purchase a townhouse in Boston for $450,000. Lisa receives an offer of employment in Atlanta, and on July 1, 1999, the Jacksons sell their townhouse for $480,000 and purchase a home in a suburb of Atlanta for $350,000. The Jacksons realize $30,000 of capital gain on their townhouse. Because they owned and resided in the townhouse for 10 months, they may exclude up to $208,333 of gain from income ($500,000 exclusion x 10 months ÷ 24 months = $208,333). Since the Jacksons’ actual gain is only $30,000, the entire amount of gain is excludable.

The IRS Restructuring and Reform Act of 1998 (P.L. 105-206) clarified an apparent conflict between the text of Code Sec. 121(c) , which prior to amendment by P.L. 105-206, referred to a proration of the realized gain and the Conference Committee Report to P.L. 105-34, which referred to a proration of the $250,000 or $500,000 exclusion limit. (Under the unamended Code text, the Jacksons in the above example would only have been able to exclude $12,500 ($30,000 realized gain x 10 months = $12,500).) The text of Code Sec. 121(c)  was clarified so that it clearly applied to a proration of the applicable exclusion and not the realized gain. 1997 Form 2119 (Sale of Your Home) was drafted by the IRS on the assumption that this technical correction would be enacted into law. Thus, no amended returns should be required to account for this amendment.

A special rule provides that the prorated exclusion (discussed above) may still be claimed even if the individual does not satisfy the two-year ownership and use tests and does not satisfy the requirement that the sale was due to an acceptable reason (e.g., change in the place of employment or unforeseen circumstances) (Act Sec. 312(d)[e](3); P.L. 105-34). However, in order to satisfy this special rule, the following two requirements must be met:

(1) the individual must have held the residence on August 5, 1997, and

(2) the sale or exchange must occur during the two-year period that began on August 5, 1997.

Example (4): Joann and Mike Davis purchased a townhouse in April, 1996 for $50,000. They rented out the townhouse until July, 1998 and began using the townhouse as their personal residence on August 1, 1998. The Davis’ received a great offer for their home and on August 1, 1999, they sold their townhouse to an eccentric artist for $350,000. The Davis’ realized $300,000 of capital gain on their townhouse. Because they owned and resided in the townhouse for 12 months, they may exclude up to $250,000 of capital gain from income ($500,000 exclusion x 12 months ÷ 24 months = $250,000). Thus, the Davis’ realized $50,000 of capital gain on the transaction ($300,000 - $250,000 = $50,000). Although the sale of their townhouse was not due to an acceptable reason (e.g., change in the place of employment or unforeseen circumstances), the Davis’ were able to use the special rule because they owned the residence on August 5, 1997 and they sold their residence before August 5, 1999 (Act Sec. 312(d)[e](3); P.L. 105-34).

Record keeping. The $250,000 or $500,000 exclusion from income eliminates the need for many homeowners to keep records of capital improvements that increase the basis of their residences. However, records of capital improvements should be kept if there is any possibility that income might be required to be recognized upon the sale of the principal residence. That situation might arise in the following circumstances:

(1) the individuals intend to live in the residence for a long period of time;

(2) the residence is rapidly appreciating in value;

(3) there is a possibility that the owners may claim a depreciation deduction for a home office or rental use of the residence; or

(4) there is a possibility that the owners may not use or own the residence long enough to qualify for the exclusion.

In other words, taxpayers should continue to hold and maintain records relating to the old rollover provisions for as long as they are subject to these rules, i.e., until after a sale triggering the recognition of deferred rollover gains, plus an additional three years for the statute of limitations.

Ownership and use of prior residences. In determining the period of ownership and use of a current residence, taxpayers may include periods of ownership and use of all prior residences with respect to which gain was rolled over to the current residence under former Code Sec. 1034 .

Incapacitated taxpayers. If an individual becomes physically or mentally incapable of self-care, the individual is deemed to use a residence as a principal residence during the time in which the individual owns the residence and resides in a “licensed care facility” (e.g., a nursing home). In order for this rule to apply, the taxpayer must have owned and used the residence as a principal residence for an aggregate period of at least one year (under the regular rules) during the five years preceding the sale or exchange (Code Sec. 121(d)(7) ). Apparently, if an elderly parent moves in with an adult child, even if professional health care workers are hired, the lower use period would not be triggered because the care was not provided in a licensed care facility. Moreover, some “assisted-living” arrangements may not qualify.

Divorced taxpayers. If a residence is transferred to a taxpayer incident to a divorce, the time during which the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership. A taxpayer who owns a residence is deemed to use it as a principal residence while the taxpayer’s spouse or former spouse is given use of the residence under the terms of a divorce or separation (Code Sec. 121(d)(3) ).

Widowed taxpayers. A taxpayer’s period of ownership of a residence includes the period during which the taxpayer’s deceased spouse owned the residence (Code Sec. 121(d)(2) ).

Remainder interests. The exclusion applies to gain on the sale or exchange of a remainder interest in a principal residence, provided the person acquiring the residence is not a member of the taxpayer’s family or other related person as defined by Code Sec. 267(b)  or Code Sec. 707(b)  (Code Sec. 121(d)(8) ).

Expatriates. The exclusion is not available to nonresident alien individuals who are subject to Code Sec. 877(a)(1)  because they gave up their U.S. citizenship for the principal purpose of tax avoidance (Code Sec. 121(e) ).

Involuntary conversions. For purposes of determining the exclusion, the destruction, theft, seizure, requisition, or condemnation of property is treated as a sale or exchange of the residence. In addition, the ownership and use of property acquired in an involuntary conversion generally includes the ownership and use of the property treated as sold or exchanged. For purposes of Code Sec. 1033 , the amount realized from the sale or exchange of property is equal to the amount of gain, reduced by the amount of gain that is permitted to be excluded from income under this new provision (Code Sec. 121(d)(5) ). A similar rule applied under former Code Sec. 121 , prior to amendment by P.L. 105-34 .

Co-ops. In the situation of a tenant-stockholder of a cooperative housing corporation defined in Code Sec. 216 , the residence ownership requirements apply to the ownership of the stock of the corporation and the use requirements apply to the house or apartment which the stockholder was entitled to occupy (Code Sec. 121(d)(4) ). This rule also applied under former Code Sec. 121 , prior to amendment.

Bankruptcy. The IRS, bowing to numerous court decisions, has taken the position that a bankruptcy estate may take the Code Sec. 121  exclusion because it is personal to the debtor (see ¶7266.19 ). In the IRS’s view, Code Sec. 1398 , when read in its entirety, supports the bankruptcy estate’s claim to the exclusion. Department of Justice attorneys have been instructed to abandon the contrary position in pending cases (Notice N(35)00-162, cancellation date August 10, 2000).