Although real estate values are declining, the homes of many of our client have substantially appreciated in value since being acquired. The provisions of Internal Revenue Code (“IRC”) Section 121, which detail the exclusion of capital gains under certain circumstances, are important to these clients. IRC Section 121 provides that a taxpayer may exclude from taxable income up to $250,000.00 of the gain realized on the sale or exchange of a principal residence, provided that the taxpayer owned and used the home as a principal residence for periods aggregating at least two years during the five years before the sale date and did not take advantage of the home sale exclusion for other property within the two year period before the sale. A qualified married couple, as well as a surviving spouse, may exclude up to $500,000.00 under certain situations. Moreover, a partial exclusion is available pursuant to IRC Regulation 1.121-3 to some taxpayers who cannot meet all of the requirements of Internal Revenue Code (“IRC”) Section 121 for the full exclusion.
I. Principal Residence
A principal residence may include a house, houseboat, house trailer or cooperative apartment, and whether or not properly qualifies as a principal residence depends
on all of the facts and circumstances. IRC Regulation Sect-ion 1-121-1(b)(1).
Where a taxpayer has more than one residence, the property used for the majority of time during the year will ordinarily be considered the principal residence. IRC Regu-lation Section 1.121-1(b)(2)(i)-(vi) provides that relevant factors in determining a taxpayer’s principal residence include, but are not limited to place of employment; the principal place of abode of her family members; the address listed on federal and state tax returns, driver’s license, automobile registration and voter registration card; mailing address for bills and correspondence; location of banks and location of religious organizations and recreational clubs with which the taxpayer is affiliated. IRC Regulation 1-121-1(b) (2).
II. Ownership and Use
The taxpayer may establish ownership and use for periods aggregating two years or more by showing ownership and use for 24 full months or for 730 days. The requirements of ownership and use may be satisfied during non-concurrent periods as long as both the ownership and use tests are met during the five year period ending on the date of the sale. IRC Regulation Section 1.121-1(c). Short, temporary absences for vacations are counted toward the period of use. IRC Regulation Section 1.121-1 (c)(2)(i).
III. Only 1 Sale Every 2 years
A taxpayer generally may not exclude from gross income the gain from the sale or exchange of a personal residence if, during the two year period ending on the date of the sale or exchange, the taxpayer sold or exchanged other property for which gain was excluded under IRC Section 121, except as otherwise provided in Regulation 1.121-3. See, IRC Regulation Section 1.121-2(b)(1).
IV. $500,000.00 Exclusion for Married Couples Filing Jointly and Surviving Single Spouse
Married couples who file jointly for the year in which the home is sold may exclude up to $500,000.00 of gain from the sale of the principal residence, provided that either spouse owned the property for at least two years during the five year period ending on the date of the sale, both spouses used the property as a principal residence for two years or more during the five year period prior to the sale, and neither spouse used the home sale exclusion on a previous sale or exchange of a home during the two year period ending on the sale date. IRC Regulation Section 1.121-2(a)(3).
If either spouse filing jointly fails to meet the above requirements, the maximum limitation amount to be claimed by the couple is the sum of each spouse’s limitation amount determined on a separate basis as if they had not been married, except that each spouse is treated as having owned the property during the period that either spouse owned it.
Before the Mortgage Forgiveness Debt Relief Act of 2007, the $500,000.00 exclusion for a married couple was available to a surviving spouse who filed a joint return with fiduciary of the estate of the deceased spouse for the year of death of the deceased spouse. IRC Regulation Section 1.121-2(a)(4), example 5.
The Mortgage Forgiveness Debt Relief Act of 2007, effective for sales and exchanges after 12/31/07, allows surviving single spouses to qualify for the $500,000.00 exclusion if the sale occurs within two years after the death of the deceased spouse and the requirements for the $500,000.00 exclusion under IRC Section 121(b)(2)(A) were met before the death of the deceased spouse.
V. Trust Ownership
IRC Regulation Section 1.121(c)(3)(i) provides that if a residence is owned by a trust, for the period that the taxpayer is treated under IRC Sections 671 through 679 as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the two year ownership requirement of IRC Section 121. In such an event, the sale or exchange by the trust will be treated as if made by the taxpayer. Moreover, if a residence is owned by an eligible entity within the meaning of IRC Section 301.7701-3(a) that has a single owner and is disregarded for federal estate tax purposes as an entity separate from its owner, such as a single member LLC, the owner will be treated as owning the residence for purposes of satisfying the two year ownership requirement of IRC Section 121 and the sale or exchange by the entity will be treated as if made by the owner. IRC Regulation 1.121-1(c)(3)(i)-(ii).
VI. Partial Home Sale Exclusion
A taxpayer may be eligible for a partial home sale exclusion if the primary reason for the sale or exchange was a change in employment, health or certain other unforeseen circumstances, even where the taxpayer fails to satisfy the ownership and use requirements described in IRC Regulation 1.121-1(a) and (c) or the two year limitation described in IRC Regulation 1.121-2(b).
A. Nursing Home Occupancy
If a taxpayer has become physically or mentally incapable of self-care and sells or exchanges property owned and used as a principal residence for periods aggregating at least one year during the five year period before the sale, the taxpayer is treated as using the property as a principal residence for any period of time during the five year period in which the taxpayer owned the property and resided in any facility, including a nursing home, licensed by a state or a political subdivision to care for an individual in the taxpayer’s condition. IRC Section 121(d)(7). The licensing requirement may pose a problem.
B. Change In Place Of Employment
The IRS will deem a sale or exchange to be within the “safe harbor” of a “change in employment” if the employment of a qualified individual changes, if the change occurs during the period that the taxpayer owned and occupied the property as a principal residence, and the new place of employment is at least 50 miles farther from the residence than was the former place of employment. IRC Regulation 1.121-3(c)(1-3).
C. Sale Due To Health
The IRS will consider a sale or exchange to be within the “safe harbor” of a sale “due to health” if the primary reason is to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury of a qualified individual, or to obtain or provide medical or personal care to a qualified individual suffering from a disease, illness or injury. A sale or exchange that is merely beneficial to the general health or well being of the individual is not deemed to be a sale or exchange by reason of health. The IRS will consider a sale or exchange to be due to health if a physician recommends a change of residence for health reasons as described above. IRC Regulation Section 1.121-3(d).
IRC Regulation Section 1.121-3(f) defines a qualified individual as the taxpayer, the taxpayer’s spouse, a co-owner of the residence, a person whose principal place of abode is in the same household as the taxpayer, a descendent of the taxpayer’s grandparent, or a person bearing a relationship specified in IRC Sections 152(a)(1) to 152(a)(8) to a qualified individual, without regard to qualification as a dependent.
D. Sale Due To Unforeseen Circumstances
i. Unforeseen Circumstances Safe Harbor
The IRS will consider a sale or exchange to be within the “safe harbor” of “unforeseen circumstances” if the primary reason for the sale or exchange was one that the taxpayer could not reasonably have anticipated before the taxpayer bought or occupied the residence, if the sale occurs during the period of the taxpayer’s ownership and use of the residence as a principal residence and if it is due to the involuntary conversion of the residence, or a natural or person-made disaster or acts of war or terrorism resulting in a casualty to the residence. Also, in the case of a qualified individual, the IRS may deem as an unforeseen circumstance the death, cessation of employment as a result of which the individual is eligible for unemployment compensation, a change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for her household, divorce or legal separation under a decree of divorce or separate maintenance or multiple births resulting from the same pregnancy. IRC Regulation Section 1.121-3(e)(2).
IRC Regulation Section 1.121-3(e)(3) provides that the commissioner may designate other events or situations as unforeseen circumstances in published guidance.
ii. Other Circumstances In Addition To Those In The Safe Harbor
If the taxpayer qualifies for the safe harbors described above, then the IRS shall deem the primary reason for the sale or exchange to be a change in place of employment, health or unforeseen circumstances and thus eligible for the reduced exclusion. If the taxpayer does not qualify for a safe harbor, the partial exclusion may still be available to the taxpayer. Factors that may be relevant in determining the taxpayer’s primary reason for the sale include, but are not limited to, the extent to which the sale and circumstances giving rise to it are proximate in time; whether the suitability of the property as the taxpayer’s principal residence materially changes; whether the taxpayer’s ability to maintain the property is materially impaired; whether the taxpayer used the property as the taxpayer’s residence during the period of the taxpayer’s ownership of the property; whether the circumstances giving rise to the sale were not reasonably foreseeable when the taxpayer began using the property as a residence; and whether the circumstances giving rise to the sale or exchange occurred when the taxpayer owned and lived in the property as her primary residence. IRC Regulation Section 1.121-3(b)(1-6).
VII. Tacking on After 2009
Pursuant to IRC Section 121(d)(10), effective for decedents dying in 2010, the decedent’s estate, heirs, and trust that was a qualified revocable trust immediately prior to the decedent’s death will be allowed to tack on the decedent’s use and ownership of the home, and will be entitled to the Section 121 exclusion. IRC Section 121(d)(10).
VIII. Sale of Partial Interests
One may exclude gain from the sale or exchange of certain partial interests of real estate. IRC Section 121(b)(3) and IRC Regulation 1.121-4(e)(i)(ii)(B). However, IRC Section 121(d)(8) provides that the IRC Section 121 exclusion shall not apply to any sale or exchange of a remainder interest in a personal residence to a related party, as described in IRC Section 267(b) or 707(b).
IX. Check the Code and Regulations
Specific rules apply the capital gains exclusion. Situations such as involuntary conversions, property used only partly as principal residence and homes acquired in a like-king exchange have specific regulations. It is wise, to review the code and regulations to determine whether the exclusion is applicable to any client’s given situation.
Sharon Kovacs Gruer, Esq., with offices in Great Neck, New York is Vice-Chair of the New York State Bar Association Elder Law Section, is former Chair of the Taxation Law Committee of the Nassau County Bar Association, is the Chair of the Trust Section of the National Academy of Elder Law Attorneys and is certified as an elder law attorney. She holds a Master of Laws (LL.M.) in Taxation from New York University.
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