EXCLUSION OF $250,000/$500,000 FROM GAIN ON PRINCIPAL RESIDENCE SALE
By: Roman P. Mosqueda, Esq.
Real Estate Broker & Attorney
What is the exclusion rule for gain on sale of principal residence?
The exclusion rule provides that up to $250,000 (or $500,000, if married and filing jointly) of gain from the sale or exchange of a principal residence on or after May 7, 1977, is not taxable at all.
In other words, up to $250,00/$500,000 of gain from the sale or exchange is not just deferred, but excludable from gross capital income. But a taxpayer may elect not to use the exclusion and have a small gain taxable, to be able to use the exclusion for a larger gain.
Indeed, effective for sale or exchange of principal residence on or after May 7, 1997, Congress repealed both the Section 1034 rollover statute (on reinvesting sales proceeds in another home within 24 months) and the old Section 121 one-time exclusion (for 55-year-old or older of $125,000).
It found the reinvestment requirement of the 24-month rollover statute as burdensome, and the one-time $125,000 exclusion for over-55 year olds limited.
And it enacted a new Section 121 in the Taxpayers Relief Act of 1997 (TRA 97), providing for up to $250,000/$500,000 of gain exclusion from gross income.
Rule In New Section 121:
For homeowners to use the permanent exclusion of gain rule in new Section 121 of the Tax Code, they must:
1. sell their principal residence, which is defined as the land and building where the taxpayer principally domiciles, or the home in the area where the taxpayer works, or where the taxpayer spends the most amount of time, if retired or not working;
2. own and use the home as the taxpayer’s principal residence for two years (aggregating two years or more) during the five-year period prior to the date of the sale or exchange of the home, the date of sale being defined, as the earlier of the date a deed passes or is delivered, or possession and burdens and benefits of ownership are transferred to the buyer;
3. not have reported any prior, post–May 7, 1997, sale or exchange for which the new Section 121 exclusion was used, during the two-year period ending on the date of the sale or exchange; and
4. as husband and wife file a joint tax return for the taxable year of the sale or exchange of their principal residence for two of the five years, to obtain the $500,000 exclusion.
It has been ruled by the Internal Revenue Service that a homeowner must satisfy the requirements of ownership and use within the five-year period prior to the date of sale or exchange. A tenant who subsequently purchases a home can count the time of tenancy therein to satisfy the use requirement.
And a homeowner who rents out his/her home can count the time of tenancy therein to satisfy the ownership requirement.
But once a principal residence is rented for more than three of the last five years, the use requirement cannot be satisfied, and the principal-residence status lost.
Thus, a rental property may still be considered a principal residence of the owner, if it is rented for less than three years of the last five years prior to the sale or exchange.
A taxpayer, who rents his/her property for more than three years, can, however, reoccupy the property as principal residence for two of the last five years before a sale or exchange, to qualify for the gain exclusion.
Exclusion Rule:
You and your wife sell your principal residence of ten years for $700, 000. Both of you purchased the home ten years earlier for $350,000, and added $50,000 of improvements.
You paid $52,000 in commissions and costs. There is no accumulated depreciation. Your net selling price is $648,000 ($700,000 minus $52,000). Your adjusted basis is $400,000 ($350,000 plus $50,000 plus 0 accumulated depreciation). So, your net gain on the sale is $248,000 ($648,000 minus $400,000).
If you use your gain exclusion of $500,000, as a married and filing-jointly couple, you have no taxable gain on the sale ($248,000 minus $500,000).
But if you and your wife sold the same principal residence for $1 million, paid $70,000 in commissions and costs, and did not take any depreciation, your net selling price is $930,000 ($1 million minus $70,000).
Your adjusted basis without any accumulated depreciation is still $400,000 ($350,000 original cost plus $50,000 of improvements). So, your net gain on the sale is $530,000 ($930,000 minus $400,000).
If you use your gain exclusion of $500,000, your taxable gain on the sale is only $30,000 ($530,000 net gain minus $500,000 exclusion), which must be included in your gross income, even though reinvested in a new residence.
$500,000 Exclusion:
For you and your wife to qualify for the $500,000 exclusion, the following requirements must be satisfied:
1. as husband and wife, both of you file a joint income tax return for the taxable year of the sale or exchange of your principal residence;
2. either of you owns the property for two of the last five years prior to the sale or exchange;
3. both of you use the property as your principal residence for two of the last five years; and
4. neither of you is ineligible because another sale or exchange was made during the previous two years for which the exclusion was used.
But even if all the above-stated requirements are not satisfied, a husband and wife will still be eligible for the $250,000 exclusion, if one spouse meets all the requirements.
Thus, if one year after you were married, your wife sold her home (acquired before the marriage) for $700,000 and realized a net gain of $248,000 on the sale, both of you do not qualify for the $500,000 exclusion because you do not meet the two-year use requirement.
But your wife meets the aforesaid ownership and use requirements. So, both of you can use the $250,000 exclusion for your wife and have no taxable gain ($248,000 net gain minus 250,000 exclusion) in your joint income tax return.
And after two years have passed since the last exclusion was allowed to your wife, both of you can use the $500,000 exclusion on your joint tax return for the sale or exchange of your principal residence, owned by either of you and used by both of you for two years of the last five years.
An experienced real estate broker and attorney and a tax advisor can assist you on gain exclusion on the sale or exchange of your principal residence.
(The Author, Roman P. Mosqueda, has been a California real estate broker since 1999 and a California real estate attorney since 1984. Before moving to California, he was a real estate broker and attorney in New York City.)