This is the first post in a series of educational posts to inform you of the income tax loopholes and landmines of Real estate transactions. Subsequent posts shall include the following topics: Rental property income, home office deduction, installment sales, vacation home with short term rentals, sales of a rental property, deferral of gain under section 1031, QOF, DST.
Section 121 Exclusion: Exclusion of Capital Gain from the sale of a primary residence
Gain Exclusion Basics
Homeowners can exclude gains up to $250,000, and married homeowners can exclude up to $500,000. At closing your title company will issue you and copy the IRS a tax form 1099-S reporting the gross sale price of the property You will report the transaction on Sch D of your 1040, citing the gain exclusion adjustment amount. Gain is taxable due to business or rental use of the home. This is calculated using Form 4797. Essentially any tax benefit derived during the course of business or rental use must be recaptured.
2 Tests to claim the Exclusion:
Ownership and Use Tests
Ownership test, you must have owned the home for at least two years out of the five-
year period ending on the sale date.
Use test, you must have used the home as your principal residence for at least two
years out of the five-year period ending on the sale date.
These two tests are completely independent and need not overlap. For purposes of the two tests, two years means periods aggregating to 24 months or 730 days.
What Counts as a Principal Residence?
IRS regulations say you must evaluate all facts and circumstances to determine whether or not a property is your principal residence for gain exclusion purposes.
If you occupy several residences during the same year, the general rule is that the principal residence for that particular year is the one where you spent the majority of time during that year. Other relevant factors can include, but are not limited to, the following:
Where you work.
Where family members live.
The address shown on your income tax returns, driver’s license, and auto registration and voter
registration cards.
Your mailing address for bills and correspondence.
Where you maintain bank accounts.
Where you maintain memberships and religious affiliations.
Special Considerations If You’re Married:
If you’re married and you and your spouse file your tax returns separately, you can potentially qualify for two separate $250,000 exclusions
Special Rule for Unmarried Surviving Spouses:
As mentioned, an unmarried individual can potentially exclude up to $250,000 of gain from selling a principal residence while a married joint-filing couple can exclude up to $500,000. But if you’re a surviving spouse, you’re not allowed to file a joint return for years after the year in which your spouse died, unless you remarry. So, you’re precluded from taking advantage of the larger $500,000 joint-filer exclusion. However, there’s an exception. Under the exception, an unmarried surviving spouse can claim the larger $500,000 exclusion for a principal residence sale that occurs within two years after the spouse’s death, assuming all the other requirements were met immediately before the spouse died.
Look-back Requirement:
If you didn't sell another home during the 2-year period before the date of sale (or, if you did sell another home during this period, but didn't take an exclusion of the gain earned from it), you meet the look-back requirement. You may take the exclusion only once during a 2-year period.
Other Considerations: To be presented in our next post: “Elect Out” of the Gain Exclusion, Moving into a residence previously used as a rental property, Exceptions to the 2 year look-back.
