Refresher: Principal Residence Gain Exclusion Break (Part 1 of 3)
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
With residential real estate markets surging, signiﬁcant unrealized gains are piling up for many homeowners. This is good news especially if you’re ready to sell, but what about the tax implications?
Thankfully, the federal income tax gain exclusion break for principal residence sales is still on the books, and it’s a potentially big deal for prospective sellers. If you’re unmarried, the exclusion can shelter up to $250,000 of home sale gain. If you’re married, it can shelter up to $500,000.
Understanding the Twists and Turns of the Maximum Federal Income Tax Savings of the Home Sale Gain Exclusion Break
This is Part 1 of our Three-Part refresher course on understanding the twists and turns necessary to realize the maximum federal income tax savings out of the home sale gain exclusion break. This might be more valuable than ever right now.
Gain Exclusion Basics
Unmarried homeowners can potentially exclude gains up to $250,000, and married homeowners can potentially exclude up to $500,000. You as the seller need not complete any special tax form to take advantage.
Report the taxable part of any principal residence gain on Schedule D of Form 1040. The current maximum federal rate for long-term capital gains is 20 percent or 23.8 percent if you owe the 3.8 percent net investment income tax (NIIT). These rates assume that lawmakers will enact no retroactive tax rate increase on gains recognized in 2021.
If part of your gain is taxable due to business or rental use of the home, you must also complete Form 4797 (Sales of Business Property). On Form 4797, you’ll calculate how much of your gain is subject to the special 25 percent maximum federal income tax rate on real property business or rental gains that are attributable to depreciation deductions. (Some prefer to think of this as the recapture tax on real property deductions.)
Warning: As explained later, you can claim a full gain exclusion only once during any two-year period.
Pass the Ownership and Use Tests
To take full advantage of the principal residence gain exclusion break, you must pass two tests: the “Ownership Test” and the “Use Test”.
- To pass the Ownership Test, you must have owned the home for at least two years out of the five-year period ending on the sale date.
- To pass the 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.
Key Point: These two tests are completely independent. In other words, periods of ownership and use 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.
- Your address is 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.
Example 1: You’re unmarried and own one home in New Jersey and another in Arizona. During 2017-2021 (ﬁve years), you spend seven months each year in the New Jersey home and the remaining ﬁve months in the Arizona home. You sell both properties on December 31, 2021, the day escrow closes. Barring unusual circumstances, tax law treats the New Jersey home as your principal residence, and you can claim the gain exclusion privilege only for that property.
Even though you owned and used the Arizona home as a residence for an aggregate of 25 months during the ﬁve-year period ending on the sale date, you cannot claim the gain exclusion for that property, because it was not your IRS-deﬁned principal residence at any time during the ﬁve-year period.
Planning Point: You look at each year for the principal residence. In this example, the New Jersey home is the principal residence for each of the ﬁve years.
But don’t give up hope. IRS regulations conﬁrm that it’s possible to simultaneously pass the ownership and use tests for two residences, as illustrated by the next example.
Example 2: You’re unmarried and own one home in Vermont and another in Florida. During 2017 and 2018, you lived in the Vermont home.
During 2019 and 2020, you lived in the Florida home.
During 2021, you once again live in the Vermont home.
In this speciﬁc scenario, you would qualify for the gain exclusion privilege if you sell either home in 2021, because you pass the two-out-of-ﬁve-years ownership and use tests for both homes. But if you sell both homes in 2021, you may claim the gain exclusion on one sale only.
The double dip you were hoping for is prohibited by the anti-recycling rule explained later.
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, as illustrated by the following example.
Example 3: You and your spouse have jointly owned a greatly appreciated home for years and have used it as your principal residence for years. For various reasons, you and your spouse ﬁle separate federal Income Tax Returns. That precludes eligibility for the $500,000 joint-ﬁler gain exclusion.
But thankfully, you and your spouse qualify for separate $250,000 exclusions because you both pass the ownership and use tests.
So, if you sell your home for a big gain, you can take advantage of a $250,000 gain exclusion, and your spouse can do the same—for a total of $500,000.
If you’re married and ﬁle jointly, you qualify for the $500,000 joint-ﬁler exclusion if:
- Either you or your spouse pass the ownership test for the property and
- Both you and your spouse pass the use test.
Example 4: Fred and Fran married after a whirlwind romance that began on a cruise ship. Immediately following the marriage, Fred sells his home for a $600,000 gain. He had owned and used the home as his principal residence for many years before he met Fran.
The newly married couple ﬁles a joint return for the year of sale.
Unfortunately, they don’t qualify for the larger $500,000 joint-ﬁler exclusion because Fran does not pass the use test for the property. Therefore, the couple must report a whopping $350,000 taxable gain on their joint Form 1040 ($600,000 – $250,000 single exclusion).
What Could Have Been: Instead of selling immediately, the couple could have lived together in Fred’s home for at least two years after the marriage. That way, they would have qualiﬁed for the larger $500,000 joint-ﬁler exclusion—because Fred would have passed the ownership test and both Fred and Fran would have passed the use test.
Here’s another thought. Fred and Fran could have lived in Fred’s home for two years before marriage, gotten married, and then qualiﬁed for the $500,000 exclusion.
Key Point: When only one spouse passes both tests, as in this example, the maximum gain exclusion is generally only $250,000. In Part 2 of this analysis (coming next week), I will explain how a prorated (reduced) gain exclusion of more than $250,000 may be available when a married joint-ﬁling couple fails to pass both tests.
When you ﬁle jointly, it’s possible for both you and your spouse to individually pass the ownership and use tests for two separate residences. In that case, you and your spouse would qualify for two separate $250,000 exclusions.
Each spouse’s eligibility for the $250,000 exclusion is determined separately as if you were unmarried. For this purpose, a spouse is considered to individually own a piece of property for any period the property is actually owned by either spouse.
Example 5: Wanda and Willie have a “commuter marriage.” Wanda works in Denver and lives most of the time in the couple’s jointly owned condo there.
Willie works in Scottsdale and lives in the couple’s jointly owned townhouse there.
On some weekends, one spouse ﬂies to the other’s city, and they both stay in their abode in that location. Under these facts, the larger $500,000 joint-ﬁler exclusion is not available for either home, because both spouses must pass the use test in order for a residence to qualify for the $500,000 exclusion.
But separate $250,000 exclusions are potentially available for each residence. Assume both the couple has owned homes jointly for ﬁve years and that Wanda passes the use test for the Denver home while Willie passes the use test for the Scottsdale home.
Under these speciﬁc facts, Wanda would qualify for a $250,000 exclusion if the Denver home is sold and Willie would qualify for a separate $250,000 exclusion if the Scottsdale home is sold.
Since each spouse’s eligibility for a $250,000 exclusion is determined separately, the two homes could be sold within two years of each other (or even in the same year) without violating the anti-recycling rule explained later. In other words, two separate $250,000 exclusions could be claimed for Wanda and Willie’s sales, even if the two sales are close together in time.
Variation: The results would be the same even if Wanda separately owns the Denver home and Willie separately owns the Scottsdale home. That’s because under the rules for joint ﬁlers, Wanda is considered to own any home actually owned by Willie, and Willie is considered to own any home actually owned by Wanda.
That means Wanda would still pass the ownership and use tests for the Scottsdale home, and Willie would still pass the ownership and use tests for the Denver home.
Special Rule for Unmarried Surviving Spouses
As stated earlier, 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. Thankfully, there’s an exception to this unfavorable general rule.
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 for the $500,000 exclusion were met immediately before the spouse died.
Key Point: The two-year eligibility period for the larger exclusion begins on the date of the deceased spouse’s death. Therefore, a sale that occurs in the second calendar year following the year of death but more than 24 months after the deceased spouse’s date of death won’t qualify for the larger $500,000 exclusion.
Beware of Anti-Recycling Rule
The other big qualiﬁcation rule for the home sale gain exclusion privilege goes like this: the exclusion is generally available only when you have not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot recycle the gain exclusion privilege until two years have passed since you last used it.
You can claim the larger $500,000 joint-ﬁler exclusion only if neither you nor your spouse took advantage of it for an earlier sale within the two-year period. If one spouse claimed the exclusion within the two-year window, but the other spouse did not, the exclusion is limited to $250,000.
All the earlier explanations assume that you are unaffected by the anti-recycling rule. If you are affected, you are Not eligible for the gain exclusion privilege unless:
- You are eligible for a prorated (reduced) gain exclusion under rules that we will cover in Part 2 of our analysis in the September issue, or
- You “elect out” of the gain exclusion privilege for the earlier sale, as explained below.
Example 6: Bennie is unmarried and an optimistic fellow. He sold his original principal residence on July 1, 2020, and excluded $250,000 of gain.
Before selling that home, Bennie purchased another property on January 1, 2020 (six months earlier), and began using it as his new principal residence.
On March 1, 2022, he decides to sell the latest home, thinking he will qualify for another gain exclusion because he owned the latest property and used it as his principal residence for more than two years. Oops! While Bennie does pass both the two-out-of-ﬁve-years ownership and use tests with ﬂying colors on the new residence, he violates the anti-recycling rule on the old residence that was sold on July 1, 2020.
Therefore, he is ineligible to exclude any gain from his 2022 sale.
When to “Elect Out” of the Gain Exclusion Privilege
As a home seller, you always have the option of “Electing Out” of the gain exclusion deal and reporting your home sale proﬁt as a taxable gain. You make the “Election Out” by reporting an otherwise excludable gain on Schedule D of Form 1040 for the year of sale. No further action is required to “Elect Out.”
Note that you can retroactively election out or revoke an earlier election out by ﬁling an amended return at any time within the three-year period beginning with the ﬁling deadline (without regard to any extension) for the Year-of-Sale return.
An obvious circumstance where the election out can be beneﬁcial is when you have two principal residence sales within a two-year period, with the later sale producing a larger gain. Consider the following example.
Example 7: You are a married joint ﬁler. You and your spouse jointly own a home in Austin, Texas, and another in Beaver Creek, Colorado. You and your spouse used the Austin property as your principal residence in 2017 and 2018.
The two of you used the Beaver Creek home as your principal residence in 2019 and 2020.
In early 2021, you sell the Austin property for a $300,000 gain. Later in 2021, you sell the Beaver Creek home for an $800,000 gain.
You and your spouse meet the two-out-of-ﬁve-years ownership and use tests for both properties. But since the Beaver Creek property was sold less than two years after the sale of the Austin property, you cannot claim the gain exclusion break for the Beaver Creek sale, because that would violate the anti-recycling rule.
Under these speciﬁc facts, you should elect out of the gain exclusion privilege for the Austin sale. You can then exclude $500,000 of gain from the more-proﬁtable Beaver Creek sale.
Make the election out by reporting the $300,000 proﬁt from the Austin sale on Schedule D included with your 2021 joint Form 1040.
In a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver. It’s one of the most valuable tax breaks for individual taxpayers.
You must pass the ownership and use tests and avoid the anti-recycling rule to claim the maximum gain exclusion of $250,000 or $500,000 for a married joint-ﬁling couple.
If you can’t do all of the above, you may still qualify for a prorated (reduced) gain exclusion in circumstances that I will explain in next week’s Part 2 of our analysis.
If you need any guidance or assistance with the current Tax Laws that welcome Federal Income Tax Savings from the Home Sale Gain Exclusion Break because you wish to retain more of what you make and multiply your net worth while remaining tax compliant, contact us at Morris + D’Angelo. This is our Expertise!
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
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