Proposed Regulations on Exclusion of Gain on Sale of Principal Residence
One of the few tax changes to benefit taxpaying Americans during the 1990s was the adoption of legislation providing for the exclusion from taxation of up to $250,000 on the sale of a principal residence ($500,000 for married taxpayers filing joint returns). The new rules represent a sharp departure from the prior rules on deferral of gain on sale of a principal residence.
Old Rules
Under prior law, taxpayers were allowed to defer the gain on a sale of their residence by reducing the tax basis of their newly acquired residence. In order to qualify, the new residence had to cost at least as much as the selling price of the old residence. This had the effect of encouraging taxpayers to "trade up" in order to avoid a tax liability. It also meant that when elderly taxpayers sold their homes, they often faced a taxable gain - if the gain exceeded the $125,000 special exclusion available under prior law.
Another significant feature of prior law was that taxpayers carried around with them a lifetime of deferred gains from sales of various homes. This prior law feature remains relevant today when a taxpayer sales a home that has a basis reduction due to the workings of prior law. Many seem unaware of this.
Another significant aspect of the new rules is that the exclusion is not allowable for any gain attributable to depreciation taken on the principal residence, such as through an office-in-home deduction or rental attributable to periods after May 6, 1997. This may impact the decision of a taxpayer to claim an office-in-home deduction, a difficult thing to qualify for in any event and one that raised the probability of audit.
Example
The proposed regulations provide the following:
"Taxpayer G, an attorney, uses a portion of her principal residence as a law office for a period in excess of three out of the five years preceding the sale of the property. Because G did not use the law office portion of the property as her residence, the exclusion doe not apply to the gain from the sale that is allocable to the law office portion of the property." (Emphasis added)
Observation: Under prior law, it was the use of the property at the time of the sale that determined if a portion of the gain was ineligible for deferral. As such, a taxpayer could cease using the property for business purposes prior to the sale and qualify the entire gain for the deferral. The gain would still have been higher to the extent of any depreciation that had been allowed (or allowable).
New Rules
The new rules permit single taxpayers to exclude from tax any gain up to $250,000. Any gain in excess of that amount is subject to tax. Unlike prior law, the purchase price of the new residence does not effect the taxability of the gain. In order to qualify, the following conditions must be met:
Reduced Exclusions
If the taxpayer(s) do not meet the Use and Ownership, they may be eligible for a reduced exclusion under certain limited circumstances as follows:
The sale/exchange is necessitated by a change in
The portion of the exclusion the taxpayer is eligible for is computed by choosing the shortest of the following three factors in months or days as the numerator (not to exceed 24 or 365)
and dividing it by 24 or 730 (the denominator).
Various Scenarios
An interesting opportunity under the regulations is provided by the following example:
Example
"Taxpayer L owns two residence, one in Virginia and one in Maine. During 1999 and 2000, L lives in Virginia residence. During 2001 and 2002, L lives in the Maine residence. During 2003, L lives in the Virginia residence. L’s principal residence during 1999, 2000 and 2003 is the Virginia residence. L’s principal residence during 2001 and 2002 is the Maine residence. Either residence would be eligible for the exclusion if it was sold during 2003. (Emphasis added)
Observation: This is a significant opportunity for taxpayers who are trying to determine which of two locations they desire to permanently reside in. Be sure to read the following example however, before getting too carried away!
Example
"Taxpayer K owns two residence, one in New York and one in Florida. From 1999 through 2003, K lives in the New York residence and lives in the Florida residence for five months. Thus, K used the New York residence a majority of the time in each year from 1999 through 2003. Therefore, in the absence of facts and circumstances indicating otherwise, the New York residence would be eligible for the exclusion if it was sold during 2003. (Emphasis added)
Observation: It appears that the opportunity presented in the previous example to treat either of two residences as eligible only works if the residences are occupied exclusively during discrete periods. Alternating back and forth periodically between two residences does not create two principal residences.
Married Taxpayers
Qualifying married taxpayers may exclude from tax any gain up to $500,000 if
There are numerous other exceptions and special rules and each circumstance requires its own analysis. "Do not attempt this analysis yourself. Professional assistance required."