Your Residence - The Ultimate Tax Shelter?

Understanding the New Rules of the Game

August 4, 2006

© 2006 by Michael C. Gray, CPA


Thanks to legislation enacted during 1997 and subsequent guidance issued by the IRS, the rules of the game have been dramatically changed relating to the sale of a principal residence. There are significant tax planning opportunities in the new rules, but some taxpayers will be worse off. Many of the old concepts have been repealed, so we need to adapt our thinking to the new rules.

Goodbye to these familiar old rules!

For example, previously we were concerned with replacing the residence with another residence with a purchase price equal to or exceeding the selling price of the former residence within a certain time frame. That rule has been repealed. No replacement residence is required. Each residence stands on its own.

Previously, "fixing up expenses" were a factor in determining the deferred gain with respect to a principal residence. Fixing up expenses are no longer part of the computation under the new rules.

Previously, taxpayers age 55 or over were eligible to exclude $125,000 of gain from the sale of a principal residence. Under the new rules, taxpayers age 55 or over are treated the same as other taxpayers.

Some winners, some losers.

Sometimes there are winners and losers of tax changes. There will be some losers in Silicon Valley under this provision. Members of Congress couldn't envision middle class homes appreciating more than $500,000, as some have here.

The new exclusion amounts.

Under the new rules, an individual may exclude from income up to $250,000 ($500,000 on a joint return) of gain realized from the sale of a principal residence.

A taxpayer may elect to recognize the gain from the sale of their residence. A taxpayer could decide to do this if the gain was small and the election enabled the taxpayer to claim the exclusion for another residence within the two-year period with a bigger gain.

Frequency of sales limit – ownership and use tests

The exclusion applies to one sale or exchange every two years. Sales before May 7, 1997 are not taken into account. The home is not required to be the principal residence at the time of purchase or sale, it only needs to meet the ownership and use tests.

Under the ownership test, the individual must have owned the residence as a principal residence for a total of at least two of the five years before the sale or exchange. Effective for sales and exchanges after October 22, 2004, the residence must have been held for more than five years after the date of acquisition if the property was acquired in a tax-deferred exchange. For example, this would apply if the property was initially used as rental property and was later converted to a principal residence.

Under the use test, the individual must have occupied the residence as a principal residence for a total of at least two of the five years before the sale or exchange.

The ownership and use tests may be met at different times, provided both tests are met for the five-year period before the sale.

Ownership and use of prior residences.

For principal residences not acquired in a tax-deferred exchange, taxpayers may include the periods of ownership and use of principal residences with respect to which gain was rolled over to the current residence under the old rules.

For example, in 1995 Jack sold a residence he bought in 1980. He replaced the residence under the old rules in 1996. In applying the tests for testing holding periods under the new law, Jack is considered as acquiring the replacement residence in 1980.

Incapacitated taxpayers.

A taxpayer who becomes physically or mentally incapable of self-care is deemed to use a residence as a principal residence during the time which the individual owns the residence and resides in a licensed care facility. In order for this exception to apply, the taxpayer must have owned and used the residence as a principal residence for at least one year during the five years before the sale or exchange.

Divorced taxpayers.

The ownership and use of a spouse or former spouse are attributed to a taxpayer to whom a residence is transferred incident to a divorce.

Widowed taxpayers.

The ownership and use of a deceased spouse are attributed to the surviving spouse.

Married individuals.

Married persons filing a joint return will qualify for the $500,000 exclusion on a joint return, provided (1) either spouse meets the ownership test, (2) both spouses meet the use test, and (3) neither spouse is ineligible for exclusion because he or she made a sale or exchange of a residence within the last two years.

Married persons who don't qualify for the $500,000 exclusion may still use the $250,000 exclusion, or a prorated exclusion, if either spouse meets the ownership and use requirements.

When a surviving spouse sells a residence, he or she will generally only be eligible for the $250,000 exclusion on his or her tax return filed as a single person, head of household or surviving spouse. It appears he or she may be eligible for the $500,000 exclusion if the residence is sold during the year of death of his or her spouse, provided the sale is reported on a final joint return. Since there is usually a basis adjustment to the fair market value of the residence as of the date of death for the decedent's interest in the property (100% for community property or the separate property of the decedent), no tax benefit will be lost unless the residence is the separate property of the surviving spouse.

Gain recognized for depreciation.

Gain up to the amount of depreciation allowable for the rental or business use of the property after May 6, 1997 will be taxable and not eligible for exclusion.

Exclusion prorated.

For principal residences except for residences acquired in a tax deferred exchange after October 22, 2004, if a taxpayer does not meet the ownership or residence requirements, a pro-rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. The amount of the available exclusion is equal to $250,000 ($500,000) multiplied by a fraction equal to the shorter of the number of months of (1) the total of periods during which the ownership and use requirements were met during the five-year period ending on the date of sale, or (2) the period after the date of the most recent sale or exchange to which the exclusion applied divided by 24 months.

For example, Jane had to sell her residence during 2004 because she had to move for a new job. She is a single person. She bought her residence on January 1, 2003 and sold it on January 1, 2004. Her available exclusion is $250,000 X 12 / 24 = $125,000. If Jane realized a gain for the sale of her residence of $100,000, the entire amount would be excluded from her taxable income.

The IRS has issued regulations that explain many alternative scenarios that are eligible for the exclusion prorate. They make it clear that taxpayers who want to upgrade their residence because of an improvement in their economic status do not qualify. Otherwise, the regulations are surprisingly liberal, including allowing taxpayers to prove they are eligible for a hardship exception because of their "facts and circumstances"!

Certain expatriates.

Nonresident aliens who gave up their US citizenship for the principal purpose of avoiding tax are not eligible for the exclusion.

Involuntary conversions.

The destruction, theft, seizure, requisition or condemnation of property is treated as a sale or exchange of the residence. Any gain in excess of the exclusion amount may be deferred by purchasing a replacement residence under the involuntary conversion rules.

Observations.

Now California seniors can get a significant exclusion of gain from the sale of their principal residences and can exclude retirement benefits from California tax when they move out of state. These are significant incentives to move to a state with no income tax, such as Washington and Nevada.

It will still be important to keep records of the improvements to your residence and your original escrow when it is likely you will sell the home for an amount over the exclusion amount and for California reporting.

For those who would have a substantial taxable gain under the new rules, it may make sense to convert the residence to rental property to be eligible for a tax-deferred exchange.

Remember that a residence that is inherited receives a new "tax basis" (cost to determine gain or loss) as of the date of death of the decedent. A residence that is held as community property is eligible to have the entire basis adjusted. However, this step-up in basis will be severely reduced if the estate tax is repealed. See your tax advisor.

Remember also that the tax basis of a residence that was a replacement residence for a pre-May 7, 1997 sale is reduced for any deferred gain from the previous sale.

An estate or trust does not qualify for the exclusion for the sale of a principal residence. As explained above, there should be little gain provided the sale takes place shortly after death.

The IRS issued rules that are surprisingly liberal for home offices. Although gain must be reported up to the amount of accumulated depreciation for a home office located within the main residence structure, it will otherwise qualify for the exclusion. A home office located in a separate structure from the main residence structure is not eligible for the exclusion. However, a separate structure home office may qualify for a tax-deferred exchange. (Rev. Proc. 2005-14.) See you tax advisor for details.

The new rules open up a whole new playing field for real estate investment on a tax-free (or minimal tax) basis.

Your residence may well be "the ultimate tax shelter"! There are significant, legitimate opportunities to be exploited by aggressive taxpayers.

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