Every so often, we get a call from taxpayers regarding the sale of a personal residence. Many wonder about the requirement to reinvest the proceeds of the sale in order to defer the gain. They are unaware that the rules regarding the sale of a personal residence changed in 1997, and they will likely be able to exclude, rather than defer, the gain.
Under the old rules, a taxpayer who realized a gain on the sale of a residence had two years after the sale date in which to buy a new residence and avoid a gain on the sale. The cost of the new residence had to equal or exceed the adjusted selling price of the old. The cost basis of the new residence was reduced by the amount of gain deferred from the sale of the prior residence. In addition, taxpayers over 55 years of age were eligible for a one-time exclusion of $125,000 of gain on the sale of a residence.
Effective May 7, 1997, Code Section 121 was added, allowing exclusion of the gain on the sale of a personal residence, rather than deferral, if certain requirements are met. A taxpayer may now exclude up to $250,000 of gain from income, $500,000 for married taxpayers filing a joint return. If the entire gain is excludable, the sale is not reported on the taxpayer’s return. In order to qualify, the home must be owned and used by the taxpayers as their principal residence for at least two of the five years preceding the sale.
In addition, the full exclusion doesn’t apply if, within the two-year period ending on the sale date, there was another home sale by the taxpayer to which the exclusion applied. For example, if the taxpayers sold their prior residence on May 28, 2001, which qualified for the exclusion, they could not claim the exclusion on another sale until May 29, 2003, even if they have lived in the current residence for two years.
As mentioned previously, married taxpayers may exclude $500,000 of gain on the sale of a residence. There are certain requirements to qualify for the full exclusion amount. First, one of the spouses must have owned the home for two of the five years before the sale. Second, both spouses must have used the home as a principal residence for at least two of the five years before the sale. Third, neither spouse has been eligible for an exclusion on the sale of another residence in the last two years.
Taxpayers who convert their residence to rental property may still be eligible for exclusion of the gain. In order to qualify, they must have used the property as their personal residence for two of the five years prior to the date of sale. For example, assume a married couple purchases a residence on April 28, 2000. On May 1, 2002, they move out of the residence and begin to rent the property. If they sell the property on or prior to May 1, 2005 they can exclude $500,000 of the gain on the sale, assuming they file a joint return. They would be required to recognize as gain, any depreciation taken during the rental period.
Taxpayers who fail to meet the two-out-of-five-year ownership and use rule may still be eligible for a partial exclusion. To qualify, the taxpayers must sell the home due to a change of place of employment, health or other unforeseen circumstances. The amount of excludable gain is prorated.
For example, assume Tom and Sally are a married couple who purchase a home on June 1, 2002. After living in the home for six months, Sally is transferred from Longmont to Chicago, and they sell the residence on Dec. 1, 2002. They can exclude $125,000 of gain assuming they are married and file a joint return. This is determined by multiplying the full exclusion amount of $500,000 by one-half year of ownership and use divided by two years.
Next month’s article will discuss additional aspects relating to the sale of a personal residence, including recognizing gain if a portion of the residence was used for business. Should you have any questions regarding the sale of your residence, consult a tax professional.
Ramin Karimi is a certified public accountant with Jensen Burcham Stelmack Edwards LLP. He can be reached at 303-651-3626.