Suppose you could receive up to $250,000 tax-free cash. Better yet, suppose you could receive up to $500,000 tax-free. Still better, suppose you could receive this tax-free money over and over again, but not more frequently than once every 24 months.
Stop dreaming. It’s possible. Thanks to Internal Revenue Code 121, millions of U.S. home sellers enjoy these tax-free benefits each year when selling their principal residences. But it is important to understand the simple rules.
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HOW TO QUALIFY FOR THIS TAX BREAK. Whether you own and live in a house, condo, cooperative apartment or other type of principal residence, you can qualify for Uncle Sam’s most generous tax exemption. To be eligible, you must have owned and occupied your primary dwelling at least 24 of the last 60 months before its sale.
Single home sellers can qualify for up to $250,000 tax-free profits. A married couple filing a joint tax return can qualify for up to $500,000 tax-free capital gains if both spouses meet the occupancy test even if only one spouse’s name is on the title.
The method of holding title doesn’t matter. Title can even be held in a revocable living trust, as millions do, to avoid probate.
However, if there are two co-owners not married to each other, then both names must be on the title for each to qualify. Military and Foreign Service members have special generous rules allowing the 24-month occupancy period as far back as 15 years before the home sale.
If you bought your principal residence as recently as 24 months ago, and occupied it since then, you meet the ownership and occupancy test. The 24-month residency need not be continuous. Brief temporary absences, such as for a 30-day vacation, count as occupancy time.
However, if you acquired your home in an Internal Revenue Code 1031 tax-deferred exchange as a rental property, and later converted it to your principal residence, for such sales after Oct. 22, 2004, you must own the property at least 60 months (24 of which it must be your principal residence).
Home sellers of any age can qualify. It doesn’t matter if you buy another replacement home or not after the sale. Nor does the dwelling have to be your residence on the date of sale.
For example, if you lived in your primary home 24 months, and then rented it to tenants up to 36 months before the sale, you still qualify for this tax exemption.
IF YOU HAVE TWO HOMES, DETERMINING YOUR PRIMARY HOME ISN’T ALWAYS EASY. Suppose you own a “summer home” and a “winter home,” as millions of U.S. homeowners do. You spend about six months each year in each home. Both residences therefore meet the 24-out-of-last-60-months IRC 121 ownership and occupancy tests.
But the IRS says only one residence can be your “main home.” This issue was vital 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 each year than in their other residences. The Wisconsin home met the 24-month ownership and occupancy tests. The owners kept bank accounts and automobiles in Wisconsin.
But the U.S. District Court ruled it was not their primary residence because the sellers never filed income tax returns from Wisconsin. As a result, they had to pay $45,009 capital gain tax on the sale of their Wisconsin home.
The IRS says principal-residence indicators — if you own more than one residence — are (1) place of employment; (2) principal abode for the taxpayer’s family members; (3) address on taxpayer’s federal and state income tax returns; (4) location of taxpayer’s banks; (5) automobile and driver’s license registrations; (6) voting location; and (7) civic affiliations, such as taxpayer’s religious organizations and other membership groups.
LITTLE-KNOWN BENEFIT FOR DIVORCED AND SEPARATED HOME SELLERS. Many divorced and separated couples are not aware they can still qualify for up to $500,000 total tax-free principal-residence-sale profits. If one divorced or legally separated spouse (called the “in spouse”) qualifies for the $250,000 tax exemption by owning and living in the home at least 24 months of the last 60 months before its sale, the other spouse (called the “out spouse”) can also qualify for up to $250,000 tax-free home-sale profits when the home is eventually sold.
This little-known tax break is often used when one spouse stays in the home until the children become 18 or 21 and the home is then sold with the profits divided between the ex-spouses.
ADJOINING VACANT LAND SALE CAN ALSO QUALIFY. Another little-known benefit of IRC 121 allows the sale of a vacant lot adjoining the principal residence to qualify for this tax exemption. However, the adjacent principal residence must be sold within 24 months before or after the lot sale.
UP TO $500,000 TAX-FREE HOME-SALE PROFIT IN YEAR OF SPOUSE’S DEATH. Although a surviving spouse should not rush to sell the principal residence in the year of a spouse’s death, IRC 121(b)(2) permits use of the exemption up to $500,000 in the year of a spouse’s death if a joint tax return is filed. In limited cases where a surviving unmarried spouse maintains a household for dependent children, this tax benefit may be available for two additional tax years.
However, a surviving spouse who inherits the deceased spouse’s share of the principal residence should be aware he or she will receive a new 50 percent “stepped-up basis” to 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 if both spouses held title.
PARTIAL EXEMPTION IF YOU DON’T MEET THE 24-MONTH OCCUPANCY TEST. If you occupied your principal residence less than the required 24 months, but the reason for your home sale is (1) change of employment site meeting the moving-cost tax-deduction rules; (2) health reasons; or (3) unforeseen circumstances, you can qualify for a partial exemption based on the number of occupancy months.
The “unforeseen circumstances” rules are still evolving. The IRS allows these acceptable reasons: (1) divorce or legal separation; (2) death in the immediate family; (3) unemployment; (4) decreased income with the homeowner unable to pay the mortgage and basic living expenses; (5) multiple births from the same pregnancy; (6) damage to the home from a natural or manmade disaster or terrorism; and (7) condemnation, seizure or other involuntary conversion of the property.
If you qualify for a partial exemption, and you occupied the principal residence 18 of the 24 required months, for example, then you qualify for 75 percent of the $250,000 or $500,000 exemption.
TWO WAYS TO AVOID TAX ON MORE THAN $250,000 OR $500,000 HOME-SALE CAPITAL GAIN. If you will have a principal-residence-sale capital gain exceeding the $250,000 or $500,000 exemptions, there are two ways to avoid tax:
1. The first method is to convert your home into a rental property. Then it qualifies for an Internal Revenue Code 1031 tax-deferred exchange for another rental or business property of equal or greater cost and equity.
Most tax advisers suggest renting your former principal residence at least six to 12 months before exchanging it. IRC 1031(a)(3), known as a “Starker exchange,” then allows selling the property, having the sale proceeds held by a qualified intermediary third-party beyond your constructive receipt, designating the replacement property within 45 days, and completing the acquisition within 180 days after the old property’s sale.
2. The second method, allowed by IRS Revenue Procedure 2005-14 effective Jan. 27, 2005, allows use of both IRC 121 and IRC 1031 in a single property sale. This slightly complicated ruling is retroactive to tax years for which the statute of limitations has not expired.
Gain is first excluded under IRC 121 up to $250,000 or $500,000, and the remaining gain then can qualify for an IRC 1031 tax-deferred exchange. An example of this procedure applies where the principal residence was converted to a rental and then the property is “down traded” for another rental property after claiming the IRC 121 exemption.
SUMMARY: Internal Revenue Code 121 is a very generous tax exemption up to $250,000 or $500,000 that can be used over and over but not more often than every 24 months for qualified home sellers. For full details, please consult your tax adviser.
Next week: Claim maximum tax savings from your second or vacation home.
(For more information on Bob Bruss publications, visit his
Real Estate Center).