As a general rule, taxpayers must include in gross income any gain that they realize from the sale or exchange of property. For example, if you buy a tractor for $25,000.00 and you sell it a month later to someone else for $35,000.00, you may have to pay income taxes on the $10,000.00 of realized gain. For many people, the most valuable asset they own is their primary residence. If you purchased a home twenty years ago for $100,000.00, but you successfully sell it this year for $250,000.00, then do you have to pay federal income taxes on the $150,000.00? Fortunately, you may be eligible under the Internal Revenue Code to exclude this gain from gross income.
As a general rule, a taxpayer does not include in gross income “gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence” for at least 2 of those last 5 years. 26 U.S.C. §121(a). “Principal residence” is limited to the property that the taxpayer resides in as a primary home and DOES NOT INCLUDE vacation homes or cottages. However, a taxpayer can only exclude gain if he or she has not already excluded gain from the sale or exchange of another principal residence within the last two years. 26 U.S.C. §121(b)(3). A taxpayer can exclude up to $250,000.00 of gain from gross income. 26 U.S.C. §121(b)(1).
In the case of a husband and wife filing a joint return, they can exclude up to $500,000.00 of gain from gross income IF ALL THE FOLLOWING ARE MET:
- EITHER spouse owns the property. 26 U.S.C. §121(b)(2)(A)(i).
- BOTH spouses used the property as the principal residence for 2 of the last 5 years. 26 U.S.C. 121(b)(2)(A)(ii).
- NEITHER spouse excluded gain from the sale or exchange of another principal residence within the last two years. 26 U.S.C. §121(b)(2)(A)(iii).
If a taxpayer whose spouse is deceased sells or exchanges his or her principal residence no later than two years after the spouse’s death (and all other criteria for spouses was met prior to death), then the taxpayer can exclude up to $500,000.00 of gain from gross income. 26 U.S.C. §121(b)(4). However, this only applies during those tax years that the surviving spouse may still file a joint tax return with the deceased spouse.
Generally, a taxpayer will not be able to exclude gain if he or she does not satisfy the use/ownership requirements of 2 of the last 5 years or has already excluded gain from another principal residence less than two years ago. However, the taxpayer may be eligible for a reduced exclusion if the unqualified sale or exchange is by reason of a change in place of employment, military deployment, health or unforeseen circumstances. 26 U.S.C. §121(c)(2). A reduced exclusion under any of these circumstances is calculated by multiplying the maximum dollar limit ($250,000.00 for single/$500,000.00 for qualified married taxpayers) by a fraction. 26 U.S.C. §121(c)(1).
- The numerator of the fraction is the LESSER OF ANY OF THE FOLLOWING:
- The time that the taxpayer owned the home during the 5-year period ending on the date of the home’s sale; OR
- The time that the taxpayer used the home during the 5-year period ending on the date of the home’s sale; OR
- The time between the date of the prior sale for which gain was excluded and the date of the current sale.
- The denominator is TWO YEARS (expressed as 24 months or 730 days).
For example, if a taxpayer buys a home and uses it as his principal residence but sells the home 18 months later because his employer transfers him to an office in another state, then he may exclude up to $187,500.00 of gain ($250,000.00 for single taxpayer x fraction of 18 months over 24 months)
The 5-year use and ownership period is suspended during any period that the taxpayer or spouse is serving on qualified official duty as a member of the Armed Forces, a member of the Foreign Service of the United States, or as a employee of the intelligence community. 26 U.S.C. §121(d)(9)(A). However, this suspension cannot be extended more than 10 years. 26 U.S.C. §121(d)(9)(B).
Any gains from an involuntary conversion (e,g. destruction, theft seizure, requisition or condemnation) is also treated as a sale or exchange for the purpose of excluded gain from taxable income. 26 U.S.C. §121(d)(5)(A). The amount realized from the sale or exchange of property is reduced by the amount of gain not included in gross income (e.g. insurance proceeds). 26 U.S.C. §121(d)(5)(B). If the taxpayer acquires a replacement home, then the holding and use period of the converted property is treated as holding and use by the taxpayer of the property sold and exchange (provided the basis of the property is determined under the IRC’s involuntary conversion rules). 26 U.S.C. §121(d)(5)(C).
For divorced couples, in the case where an individual holding property acquired pursuant to a divorce or separate maintenance agreement, the use/ownership period includes any period that the former spouse owned the property. 26 U.S.C. §121(d)(3). For example, if a spouse acquired a home six months ago in a divorce from a former spouse (who owned and used it for ten years prior), then the spouse will be eligible for the full exclusion of gain under this statute.
Some tax planning may be required for newly married couples who both owned homes during the marriage. If both houses could be sold for a gain, the couple should consider selling the home with the least amount of gain first (since the single spouse will be limited to excluding $250,000.00 of gain). The couple can reside in the house with the greater gain, then sell that home two years later and exclude up to $500,000.00 on a joint return. The house with the greater gain cannot be sold less than two years after the sale of the house with the lesser gain (unless the transaction qualified due to change in employment, health or unforeseen circumstances).
If the Internal Revenue Services determines that your home does not qualify for the exclusion of gain, then you can be subject to a substantial tax liability on the additional income. Before you sell your home, you should seek the advice of a qualified tax professional to ensure that you do not run into nasty surprises at tax time. If you have questions about the home gain exclusion or any aspect of federal taxation, then do not hesitate to contact the attorneys at Kershaw, Vititoe & Jedinak PLC today.