Refresher: Principal Residence Gain Exclusion Break (Part 3 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 sizzling, signiﬁcant unrealized gains are piling up for many homeowners. That’s good news if you’re ready to sell, but what about the tax implications? Good question.
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. That helps!
This is Part 3 of our three-part refresher course on how to navigate the twists and turns necessary to wring the maximum federal income tax savings out of the home sale gain exclusion break, which might be more valuable than ever right now.
For Part 1 and Part 2 of our analysis, see Refresher: Principal Residence Gain Exclusion Break (Part 1 of 3) and Refresher: Principal Residence Gain Exclusion Break (Part 2 of 3).
Let’s now get started with Part 3.
How to Exclude Gain in Marriage and Divorce Situations
In both marriage and divorce situations, a home sale often occurs. Of course, the principal residence gain exclusion break can come in very handy when an appreciated home is put on the block.
Sale during Marriage
Say a couple gets married. They each own separate residences from their single days. After the marriage, the pair ﬁles jointly. In this scenario, it is possible for each spouse to individually pass the ownership and use tests for their respective residences. Each spouse can then take advantage of a separate $250,000 exclusion.
Put another way, each spouse’s eligibility for a separate $250,000 exclusion is determined independently, as if the couple were still unmarried.
Example 1: You get married and decide to move into your spouse’s home. You also own a home. Neither of you had lived in the other’s home before the marriage.
You and your new spouse ﬁle jointly. Shortly after the marriage, your spouse sells her home. You can exclude up to $250,000 of gain from that sale as long as your spouse
- Owned and used the property as her principal residence for at least two years out of the five-year period ending on the sale date, and
- Did not exclude gain from an earlier sale within the preceding two years.
You may also decide to sell your home. You can exclude up to $250,000 of gain as long as you individually pass the same ownership and use tests. It does not matter if the sale of your home occurs within two years of the sale of your spouse’s home.
Variation: Assume the sale of your home would trigger a $450,000 gain. In that case, you and your spouse should
- Live together in your home for at least two years, and
- Make sure at least two years have elapsed since the sale of your spouse’s home.
Then you can sell your home and be eligible for the larger $500,000 joint-ﬁler exclusion. That would shelter your entire gain from any federal income tax hit.
Sale before Divorce
Say a soon-to-be-divorced couple sells their principal residence. Assume they still are legally married as of the end of the year of sale because their divorce is not yet ﬁnal. In this scenario, the divorcing couple can shelter up to
$500,000 of home sale proﬁt in two different ways:
- Joint return. The couple could file a joint Form 1040 for the year of sale. Assuming they meet the timing requirements, they can claim the $500,000 joint-filer exclusion.
- Separate returns. Alternatively, the couple could file separate returns for the year of the sale, using married-filing-separately status. Assuming the home is owned jointly or as community property, each spouse can then exclude up to $250,000 of his or her share of the gain.
To qualify for two separate $250,000 exclusions, each spouse must have
- Owned his or her part of the property for at least two years during the five-year period ending on the sale date, and
- Used the home as his or her principal residence for at least two years during that five-year period.
Key Point: In many cases, the preceding favorable rules will allow the divorcing couple to convert their home equity into tax-free cash. They can generally divide up that cash any way they choose without any further federal tax consequences and then go their separate ways.
Sale in Year of Divorce or Later
When a couple is divorced as of the end of the year in which their principal residence is sold, they are considered divorced for that entire year. Therefore, they will be unable to ﬁle jointly for the year of sale. The same is true, of course, when the sale occurs after the year of divorce. Here’s the home sale gain exclusion drill in these situations.
Example 2: Ex-spouse Andy winds up with sole ownership of the residence, which was formerly owned solely by ex-spouse Briana, in a federal tax-free divorce-related transfer.
In this scenario, when Andy eventually sells the property, he is allowed to count Briana’s period of ownership for purposes of passing the two-out-of-ﬁve-years ownership test.
Andy’s maximum gain exclusion will be $250,000 because he is now single.
But if he remarries and lives in the home with the new spouse for at least two years before selling, Andy can qualify for the larger $500,000 joint-ﬁler exclusion.
Example 3: This time let’s say that ex-spouse Andy winds up owning some percentage of the home, while
ex-spouse Briana winds up owning the rest. When the home is later sold, both Andy and Briana can exclude $250,000 of their respective shares of the gain, provided each person:
- Owned his or her share of the home for at least two years during the five-year period ending on the sale date, and
- Used the home as his or her principal residence for at least two years during that same five-year period.
Key Point: Under the preceding rules, both ex-spouses will typically qualify for separate $250,000 gain exclusions when the home is sold soon after the divorce. But when the property remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-ﬁve-years use to test and become ineligible for the gain exclusion privilege.
Let’s see how we can avoid that unpleasant outcome.
When the Non-Resident Ex Continues to Own the Home for Years after Divorce
Sometimes ex-spouses will continue to co-own the former marital abode for a lengthy period after the divorce. Of course, only one ex-spouse will continue to live in the home. After three years of being out of the house, the non-resident ex will fail the two-out-of-ﬁve-years use test. That means when the home is ﬁnally sold, the non-resident ex’s share of the gain will be fully taxable. But with some advance planning, you can prevent this undesirable outcome.
If you will be the non-resident ex, your divorce papers should stipulate that as a condition of the divorce agreement, your ex-spouse is allowed to continue to occupy the home for as long as he or she wants, or until the kids reach a certain age, or for a speciﬁed number of years, or for whatever time period you and your soon-to-be-ex can agree on. At that point, either the home can be put up for sale, with the proceeds split per the divorce agreement, or one ex can buy out the other’s share for current fair market value.
This arrangement allows you, as the non-resident ex, to receive “credit” for your ex’s continued use of the property as a principal residence. So, when the home is ﬁnally sold, you should pass the two-out-of-ﬁve-years use test and thereby qualify for the $250,000 gain exclusion privilege.
The same strategy works when you wind up with complete ownership of the home after the divorce, but your ex continues to live there. Stipulating as a condition of the divorce that your ex is allowed to continue to live in the home ensures that you, as the non-resident ex, will qualify for the $250,000 gain exclusion when the home is eventually sold.
Example 4: Dave and Della are divorced in September 2021. Each party retains 50 percent ownership of the former marital abode.
A speciﬁc condition of the divorce agreement stipulates that Della is allowed to continue to reside in the home for up to six years, at which point the couple’s youngest child will reach age 18. Then Della must either buy out Dave’s 50 percent ownership interest based on the market value at that time or cooperate in selling the home.
Assume the property is indeed sold six years after the divorce.
With respect to his 50 percent ownership interest, Dave still passes the two-out-of-ﬁve-years ownership and use tests even though he has not lived in the home for six years. That’s because he made sure the divorce agreement included the magic words: the provision speciﬁcally permitting Della to continue to reside in the home.
Because of the magic words, Dave can count Della’s continued use of the property as her principal residence as continued use by him. That means Dave will qualify for the $250,000 gain exclusion privilege when the home is sold, six years after the divorce. He can use the exclusion to shelter all or part of his share of the home sale proﬁt.
Key Point: If Dave’s attorney fails to include the magic words in the divorce papers, Dave will be taxed on his share of the home sale gain when the property is sold, six years after the divorce.
Della also passes the ownership and use tests. So, she also qualiﬁes for a separate $250,000 gain exclusion, assuming she remains single.
Say Della remarries during this six-year period. She and her new husband, Max, live in the home for at least two years before the sale date. With respect to her share of the home sale gain, Della can qualify for the larger $500,000 exclusion by ﬁling a joint Form 1040 with Max for the year of sale.
With respect to his share of the gain, Dave still qualiﬁes for a $250,000 exclusion, as explained above.
Example 5: Assume the same basic facts as in the previous example, except this time Dave has 100 percent ownership of the former marital abode after the divorce. A speciﬁc condition in the divorce agreement stipulates that Della can continue to reside in the home for up to six years. After that, Dave can sell the home at any time by giving Della three months’ notice of his intent to sell.
The property is sold six years and three months after the divorce. Dave still passes the two-out-of-ﬁve- years ownership and use tests even though he has not lived in the home for over six years. So, he qualiﬁes for the $250,000 gain exclusion privilege, which he can use to shelter all or part of his home sale proﬁt.
Key Point: As we noted earlier, if Dave’s attorney fails to include the magic words in the divorce agreement, Dave will be taxed on the entire home sale gain six years after the divorce.
Little-Known Non-Excludable Gain Rule Can Mean Unexpectedly Higher Taxes on a Property Converted into Your Principal Residence
Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the home sale gain exclusion privilege of $250,000 for unmarried individuals or $500,000 for married, joint-ﬁling couples. Those were the good old days!
Unfortunately, legislation enacted back in 2008 included an unfavorable provision for personal residence sales that occur after that year. The provision can make a portion of your gain from selling an affected residence ineligible for the gain exclusion privilege.
Let’s call the amount of gain that is made ineligible the non-excludable gain. The non-excludable gain amount is calculated as follows.
Step 1: Take the total gain, and subtract any gain from depreciation deductions claimed against the property for periods after May 6, 1997. Include the gain from depreciation (so-called unrecaptured Section 1250 gain) in your taxable income.12 Carry the remaining gain to Step 3.
Step 2: Calculate the non-excludable gain fraction.
The numerator of the fraction is the amount of time after 2008 during which the property is not used as your principal residence. These times are called periods of non-qualiﬁed use.
But periods of non-qualiﬁed use don’t include temporary absences that aggregate two years or less due to changes of employment, health conditions, or other circumstances speciﬁed in IRS guidance.
Periods of non-qualiﬁed use also don’t include times when the property is not used as your principal residence, if those times are:
- After the last day of use as your principal residence, and
- Within the five-year period ending on the sale date. (See Example 10 below.)
The denominator of the fraction is your total ownership period for the property.
Step 3: Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.
Step 4: Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. Also report any Step 1 unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements.
Example 6: Emmy, a married joint-ﬁler, bought a vacation home on January 1, 2013. On January 1, 2017, she converted the vacation home into her principal residence, and she and her spouse lived there from 2017 through 2021. On January 1, 2022, Emmy sells the property for a $600,000 gain. Her total ownership period is nine years (2013-2021).
The four years of post-2008 use as a vacation home (2013-2016) result in a non-excludable gain of
$266,667 (4/9 x $600,000). Emmy must report the $266,667 on her 2022 Schedule D as a long-term capital gain and must absorb the resulting federal income tax hit.
She can shelter the remaining $333,333 of gain ($600,000 – $266,667) with her $500,000 gain exclusion.
Example 7: Assume the same basic facts as in the preceding example, except this time, assume that
Emmy has $10,000 of unrecaptured Section 1250 gain from renting out the property before converting it into her principal residence. Therefore, the total gain on sale is $610,000.
- Emmy must report the $10,000 of unrecaptured Section 1250 gain on her 2022 Schedule D.
- She must also report the non-excludable gain of $266,667 [4/9 x ($610,000 – $10,000)] on her 2022 Schedule D.
- She can shelter the remaining $333,333 of gain ($610,000 – $10,000 – $266,667) with her
$500,000 gain exclusion.
Example 8: Freeman is a single guy. He bought a vacation home on January 1, 2009. On January 1, 2013, he converted the property into his principal residence, and he lived there from 2013-2021.
On January 1, 2022, he sells the property for a $700,000 gain. Freeman’s total ownership period is 13 years (2009-2021). The four years of post-2008 use as a vacation home (2009-2012) result in a non-excludable gain of $215,385 (4/13 x $700,000).
Freeman qualiﬁes for the $250,000 gain exclusion.
Ignoring the impact of the non-excludable gain rule, he must report a $450,000 gain on his 2022 Schedule D ($700,000 – $250,000). Since the $450,000 gain that he must report exceeds the $215,385 non- excludable gain, the non-excludable gain rule has no impact on Freeman. He reports a gain of $450,000 on his 2022 Schedule D.
Example 9: Assume the same basic facts as in the preceding example, except this time, assume that Freeman has only a $300,000 gain when he sells the property on January 1, 2022. Therefore, he has a non-excludable gain of $92,308 (4/13 x $300,000), which he must report on his 2022 Schedule D.
Freeman can use his $250,000 gain exclusion to shelter the remaining $207,692 of gain ($300,000 – $92,308).
Key point: The results in Examples 8 and 9 reveal the interesting truth that the non-excludable gain rule can hurt sellers with smaller gains while having no impact on sellers with larger gains.
Example 10: Gemma is a married joint-ﬁler. She bought a vacation home on January 1, 2013. On January 1, 2016, she converted the property into her principal residence, and she lived there with her husband from 2016 through 2019.
She then converted the home back into a vacation property and used it as such for 2020 and 2021. Gemma then sells the property on January 1, 2022, for a $540,000 gain. Her total ownership period is nine years (2013-2021).
The ﬁrst three years of post-2008 use as a vacation home (2013-2015) result in a non-excludable gain of $180,000 (3/9 x $540,000). Gemma must report the $180,000 as a long-term capital gain on her 2022 Schedule D. Since she’s eligible for a $500,000 gain exclusion, she can exclude the remaining $360,000 of gain ($540,000 – $180,000).
Key Point: The last two years of use of Gemma’s property as a vacation home (2020-2021) don’t count as periods of non-qualiﬁed use because they occur:
- After the last day of use as a principal residence (December 31, 2019) and
- Within the five-year period ending on the sale date (January 1, 2022).
Therefore, Gemma’s use of the property as a vacation home in 2020 and 2021 doesn’t make her non- excludable gain any larger.
Tax Planning Implications of Non-Qualiﬁed Use
As you see, the unfavorable rule explained above can take some of the tax-saving fun out of converting a vacation home or rental property into your principal residence.
That said, a reduced gain exclusion is better than no exclusion at all.
In addition, the unfavorable rule is less likely to affect highly appreciated properties (compare the results in Examples 8 and 9). Finally, converting a property into your principal residence sooner rather than later can give you a better tax result, because it minimizes the period of non-qualiﬁed use.
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.
To claim the maximum gain exclusion of $250,000 or $500,000 for married joint-ﬁlers, you must pass the ownership and use tests and avoid the anti-recycling rule. See Part 1 of our analysis for details on these restrictions.
If you’re affected by the aforementioned restrictions, you may still qualify for a prorated (reduced) gain exclusion under the rules explained in the earlier Part 2 of our analysis.
If you are getting married or divorced, make sure you pay attention to the December 31 rule: if you are married on December 31, you are married for the year.
In a divorce, if your ex is going to live in the home for a number of years, make sure your divorce lawyer includes the “living there stipulation” in the divorce papers so that you preserve your $250,000 exclusion.
If in 2009 or later, you converted a vacation home or rental property into your personal residence, make sure to understand the non-qualiﬁed use rule and its impact, if any, on your taxable gain from the sale of that residence.
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