By Adam G. Kirk, published on May 28, 2005, in Savannah Morning News.
A surge in real estate prices has created significant equity in the principal residences of many people in our area. This equity creates tax exposure for those tempted to cash in on the gain in value of their principal residences.
When selling a principal residence, taxpayers should be sure to take advantage of the home sale gain exclusion provided by the Internal Revenue Code.
Since 1997, the Internal Revenue Code has allowed a taxpayer to exclude from taxable income the gain (up to a maximum gain exclusion of $500,000, for certain married taxpayers) from the sale of the taxpayer’s principal residence, so long as the taxpayer owned and occupied the property as a principal residence for two of the five years preceding the sale.
Many are surprised at the flexibility the IRS has given the exclusion. The two-year period of ownership and period of residence need not be concurrent.
Say Jane, a single taxpayer, rents a condominium for one year before buying it, then lives in the condominium for another year and a half.
Jane then moves and leases the condominium for a year to a tenant, before selling the condominium at a gain of $100,000. Jane has thus lived in the condominium for two and a half of the five years preceding the sale, and owned the condominium for two and a half of the five years preceding the sale.
Under IRS regulations, Jane is entitled to the full home sale gain exclusion despite the fact that her period of ownership and period of occupancy were not the same. Since the maximum exclusion for single taxpayers is $250,000, Jane will not be taxed on any of her home sale gain.
Some taxpayers are eligible for the reduced home sale gain exclusion even if they don’t meet the two year ownership and occupancy requirements.
In certain circumstances, a reduced exclusion is available if a taxpayer’s failure to meet the ownership and occupancy requirements of the home sale gain exclusion is due to a change in place of employment, health problems, or unforeseen circumstances.
Using the preceding example, let’s say Jane’s employer transferred her and she sold the condominium exactly six months after she bought it. Jane has thus lived in the condominium for one and a half years, and owned the condominium for half a year at the time of sale.
Under IRS regulations, the reduced exclusion is calculated by multiplying the maximum exclusion ($250,000) by a fraction equal to the shorter of the period of ownership or occupancy, divided by two years (in this case, 0.5 year/2 years = 0.25 ).
Jane is entitled to a reduced home sale gain exclusion of $62,500, or a quarter of the maximum exclusion of $250,000. Jane must pay taxes on the remaining $37,500 of the gain on the sale of her house.
As demonstrated in the preceding example, timing is crucial to home sale gain exclusion.
Jane could have increased the amount of home sale gain exclusion available to her by delaying the closing of the sale, or by leasing the condominium until the end of the required period.
The home sale gain exclusion may only be taken by a taxpayer once every two years.
If a taxpayer does not meet the periods of ownership and occupancy required and cannot demonstrate eligibility for the reduced exclusion described above, the taxpayer is not entitled to any home sale gain exclusion.
This may come as a surprise to those familiar pre-1997 rules, which entitled a taxpayer to an exclusion to the extent proceeds of the sale of a principal residence were reinvested in a new principal residence.
Finally, taxpayers that use their primary residence for business purposes and take related deductions for tax purposes are not entitled to the home sale gain exclusion for the portion used for business purposes.
Because IRS regulations in this area are complex, taxpayers should seek tax advice when seeking to claim the reduced home sale gain exclusion if they have used their home for business purposes, or do not meet the two year periods of ownership and occupancy.
Adam Kirk is the Hiring Partner at HunterMaclean and practices in the areas of taxation, corporate and real estate law. He can be reached at email@example.com or 912-236-0261.