The New Principal Residence Regulations

The New Principal Residence Regulations

By Lisa Church, Joseph P. Matoney, and Mark Higgins

In Brief

IRS Regulations Provide Myriad Options to Tough Questions

On December 23, 2002, the Treasury Department published final regulations related to the exclusion of gain from the sale or exchange of a principal residence. Because the Treasury Department received numerous comments regarding questions about a reduced exclusion because of health, employment, or other unforeseen circumstances, provisions related to such contingencies were issued as only temporary regulations rather than as part of the final regulations. The authors explain the final regulations and discuss the temporary regulations for unforeseen circumstances, using a number of examples drawn from the regulations.

Under IRC section 121, a married couple filing a joint income tax return can exclude up to $500,000 of capital gain on the sale of their primary residence. Single individuals may exclude up to $250,000. To qualify for the exclusion, the home must be the taxpayer’s primary residence for two of the five years prior to the date of sale. There is no limit to how many times the exclusion may be used as long as two years elapse between qualifying sales.

Example 1. In 1997, Mary purchased a single-family home for $100,000 and used it as her primary residence. After living in the home for five years, she sold it for $250,000 (net of selling expenses) on June 1, 2002. The entire gain of $150,000 is excluded from income and no tax is due. Mary does not need to purchase another home in order to receive this tax benefit.

Ownership and Use Tests

The gain exclusion is available to individuals meeting both the ownership test and the use test during the five-year period ending on the date of the sale. The ownership test requires that the home be owned for two years, and the use test requires that the home be occupied as the taxpayer’s principal residence for two years. The two-year ownership and two-year use requirement must be satisfied within the five-year period ending on the date of sale. The two-year period of use as a principal residence need not be continuous. In addition, short-term temporary absences for vacation or other seasonal purposes generally do not disqualify the taxpayer from taking the exclusion.

Example 2. Continuing with the conditions in Example 1, assume that Mary purchases another home on July 1, 2002, for $275,000, and sells it on April 1, 2004, for $325,000. Mary is precluded from excluding any of the $50,000 gain ($325,000 – $275,000) on this transaction because she has already excluded the gain on a sale of a home within the two-year period (June 1, 2002–May 31, 2004). If Mary had waited to sell after July 1, 2004, she could have excluded the entire $50,000 gain.

The regulations also explain that if a taxpayer alternates between two properties, the property that the taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayer’s principal residence.

Example 3. Carl owns two residences, one in New York and one in Florida. He lived in the New York residence for seven months and the Florida residence for five months of each year from 1999 through 2004. In the absence of facts and circumstances indicating otherwise, the New York residence is Carl’s principal residence. Carl would be eligible for the IRC section 121 exclusion of gain from the sale or exchange of the New York residence, but not the Florida residence.

To help taxpayers that own multiple homes determine which should be considered their principal residence, the final regulations include a list of factors that are relevant in identifying a taxpayer’s principal residence:

If the taxpayer alternates between two properties on a yearly or biannual basis, assuming the taxpayer meets the ownership and use tests, the taxpayer will be able to choose which residence to apply the exclusion to.

Example 4. Beth owns two residences, one in Virginia and one in Maine. During 1999, 2000, and 2003, she lived in the Virginia residence. During 2001 and 2002, she lived in the Maine residence. Beth’s principal residence for 1999, 2000, and 2003 is the Virginia residence. Beth’s principal residence for 2001 and 2002 is the Maine residence. Beth would be eligible for the IRC section 121 exclusion of gain from the sale or exchange in 2003 of either residence—but not both.

Vacant Land

Another problem some taxpayers face when selling their principal residence is whether the vacant land surrounding a residential structure can be treated as part of the residence. Under IRC section 1034 (the predecessor to IRC section 121), a sale of vacant land that did not include a dwelling unit did not qualify as a sale of the taxpayer’s residence. If the sale of vacant land was part of a series of transactions that included the sale of the house and the series of transactions all occurred during the IRC section 1034 replacement period (two years before or after the date of the taxpayer’s purchase of a replacement residence), the sale of vacant land and the sale of the house were treated as one sale.

The final regulations provide that IRC section 121 will apply to the sale or exchange of vacant land if the taxpayer has owned and used that land as part of the taxpayer’s principal residence and that land is adjacent to the dwelling unit. In addition, the regulations permit the sale of the land to be treated as part of the sale of the dwelling unit as long as the sale or exchange of the dwelling unit occurs within two years before or after the sale or exchange of the vacant land.

Example 5. In 1991, Christopher bought property consisting of a house and 10 acres that he used as his principal residence. In May 2002, he sold eight acres of the land, realizing a gain of $110,000. If Christopher did not sell the dwelling unit before the due date for filing his 2002 tax return, he would not be eligible to exclude the $110,000 gain at that time. In March 2004, Christopher sells the house and remaining two acres, realizing a gain of $180,000 that may be excluded. Because the sale of the eight acres occurred within two years of the date of sale of the dwelling unit, it is treated as a sale of the taxpayer’s principal residence under Treasury Regulations section 1.121-1(b)(3). Christopher may file an amended return for 2002 to claim the exclusion for $70,000 ($250,000 – $180,000 gain previously excluded) of the $110,000 gain from the sale of the eight acres.

Example 6. In 1998, Diane bought a house and one acre that she used as her principal residence. In 1999 she bought 29 acres adjacent to her house and used the vacant land as part of her principal residence. During 2003 Diane sold the house and one acre of the land at a loss of $25,000. Later that year, she sold the remaining 29 acres at a gain of $20,000. Since the two transactions occurred within two years, she is able to combine the two transactions, and no gain is recognized.

Incapacitation

If a taxpayer has become physically or mentally incapable of caring for himself and has owned and used the principal residence for at least one year during the five-year period preceding the sale or exchange, the taxpayer will be treated as using the property as a principal residence for any period of time during the five-year period.

Example 7: In January 1999, Thomas bought a house for $250,000 and used it as his principal residence. During October 2000, Thomas suffered a stroke. In 2002, his son, holding his power of attorney, sold the house for $390,000. Because Thomas lived in the house for at least one year during the proceeding five-year period, he can exclude the entire gain of $140,000 ($390,000 – $250,000).

Depreciation

The IRC section 121 exclusion does not apply to the portion of the gain from the sale or exchange of property that results from depreciation taken on the property after May 6, 1997. Depreciation adjustments allocable to any portion of the property to which the exclusion does not apply under Treasury Regulations section 1.121-1(e) are not taken into account for this purpose.

Example 8. On July 1, 1999, Donald moved into a house that he owned and had leased to tenants since July 1, 1997. Donald took depreciation deductions totaling $14,000 for the period that he leased the property. After occupying the residence as his principal residence for two full years, Donald sold the property on August 1, 2001, realizing a gain of $40,000. Only $26,000 ($40,000 gain realized – $14,000 depreciation deductions) may be excluded.

Mixed-Use Property

The final regulations also require that if the property is used only in part as a principal residence, the taxpayer must allocate the gain between the residential and nonresidential portions of the property. For purposes of determining gain, the taxpayer must allocate the basis and the amount realized using the same method of allocation used to determine depreciation adjustments. Property sold or exchanged must satisfy the use requirement to qualify for the IRC section 121 gain exclusion. Thus, if a portion of the property (separate from the dwelling unit) was used for nonresidential purposes, the gain allocable to it is not excludable. Alternatively, no allocation is required if both the residential and nonresidential portions of the property are within the same dwelling unit.

Example 9. Alex owned property that consisted of a house, a stable, and 35 acres. Alex used the stable and 28 acres for nonresidential purposes for more than three years during the five-year period preceding the sale. Alex used the entire house and the remaining seven acres as his principal residence for at least two years during the five-year period preceding the sale. For periods after May 6, 1997, Alex claimed depreciation deductions of $9,000 for the nonresidential use of the stable. Alex sells the entire property in 2004, realizing a gain of $24,000. Because the stable and the 28 acres used in the business are separate from the dwelling unit, the allocation rules apply. Alex determines that $14,000 of the gain is allocable to the nonresidential-use portion of the property and that $10,000 is allocable to the residential-use portion. Alex must recognize the $14,000 of gain allocable to the nonresidential-use portion of the property. (The $14,000 gain consists of the unrecaptured IRC section 1250 gain of $9,000 and $5,000 of IRC section 1231 gain.) Alex may exclude $10,000 of the gain from the sale of the property.

Example 10. In 1998, Bettina bought a property that included a house, a barn, and two acres. Bettina used the house and two acres as her principal residence and the barn for an antiques business. In 2002, Bettina moved out of the house and rented it to tenants. Bettina sells the property in 2004, realizing a gain of $21,000. Between 1998 and 2004, Bettina claimed depreciation deductions of $4,800 attributable to the antiques business; between 2002 and 2004, Bettina claimed depreciation deductions of $3,000 attributable to the house. Because the portion of the property used in the antiques business is separate from the dwelling unit, the allocation rules apply. Bettina determines that $4,000 of the gain is allocable to the nonresidential portion of the property and that $17,000 of the gain is allocable to the residential portion. Bettina must recognize the $4,000 gain allocable to the nonresidential portion of the property. In addition, the IRC section 121 exclusion does not apply to the $3,000 gain allocable to the residential portion of the property to the extent of the depreciation adjustments attributable to the residential portion of the property for periods after May 6, 1997, meaning that only $14,000 of the gain may be excluded.

Example 11. In 2002, Curtis bought a three-story townhouse and converted the basement level, which had a separate entrance, into a separate apartment by installing a kitchen and bathroom and removing the interior stairway. After the conversion, the property constituted two dwelling units. Curtis used the first and second floors of the townhouse as his principal residence and rented the basement level to tenants from 2003 to 2007. Curtis claims depreciation deductions of $2,000 for that period for the basement apartment. Curtis sells the entire property in 2007, realizing a gain of $18,000. Because the basement apartment and the upper floors of the townhouse are separate dwelling units, Curtis must allocate the basis and the amount of gain realized between the residential and nonresidential portions of the property. Curtis determines that a $6,000 gain is allocable to the nonresidential portion and that $12,000 is allocable to the residential portion. Curtis must recognize the $6,000 gain allocable to the nonresidential portion (unrecaptured IRC section 1250 gain of $2,000 and IRC section 1231 gain of $4,000), and may exclude $12,000 of the gain.

Example 12. The facts are the same as in Example 11, except that in 2007 Curtis incorporates the basement of the townhouse into his principal residence by eliminating the kitchen and building a new interior stairway. Curtis uses all three floors of the townhouse as his principal residence for two full years and sells the townhouse in 2010, realizing a gain of $20,000. Curtis must recognize $2,000 as unrecaptured IRC section 1250 gain, but may exclude the remaining $18,000 of the gain from the sale of the house.

Reduced Maximum Exclusion

A reduced maximum exclusion is available if the ownership and use tests were not met due to a change in employment, health, or particular unforeseen circumstances. For qualified sellers, the maximum exclusion amount of $250,000 ($500,000 for a married couple filing jointly) is limited to the percentage of the required two years that the tests were met. A qualifying seller who owns and occupies a home for one year and who has not excluded gain on another home in that time may exclude half the regular maximum amount, $125,000; the proportion may be figured in days or months.

On December 23, 2002, the Treasury Department published temporary regulations under IRC section 121 regarding the provisions for the reduced maximum exclusion. The temporary regulations indicate that the reduced maximum exclusion will be allowed only if the primary reason for the sale or exchange is a change in place of employment, health, or unforeseen circumstances under IRC section 121(c). The temporary regulations establish safe harbor provisions; additionally, taxpayers may establish by the facts and circumstances that the sale of their home qualifies for a reduced maximum exclusion due to a change in place of employment, health, or unforeseen circumstances. The provisions under the temporary regulations apply to qualified individuals, including the taxpayer; the taxpayer’s spouse; a co-owner of the residence; or a person whose principal place of abode is in the same household as the taxpayer.

Change in Place of Employment

The reduced maximum exclusion is available to a taxpayer if the primary reason for the sale or exchange is a change in place of employment. Under the safe harbor provisions, a change in place of employment occurs if it takes place during the period of the taxpayer’s ownership and use of the property as a principal residence, and if the individual’s new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment. (If there was no former place of employment, the distance between the individual’s new place of employment and the residence sold or exchanged must be at least 50 miles.) Employment includes the commencement of employment with a new employer, the continuation of employment with the same employer, and the commencement or continuation of self-employment. This test for a change in place of employment is the same as that for the moving expense deduction under IRC section 217.

Example 13. Alicia was unemployed and owned a townhouse that she had owned and used as her principal residence since 2002. In 2003, Alicia obtained a job 54 miles from her townhouse, which she then sold. The sale meets the safe harbor provisions, and Alicia is entitled to claim a reduced maximum exclusion under IRC section 121(c)(2).

Health Reasons

The reduced maximum exclusion is also available if the primary reason for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. To qualify under the safe harbor provisions, a physician must recommend the change of residence. A sale or exchange that is merely beneficial to the general health or well-being of the individual does not qualify.

The rules regarding qualified individuals, which are enumerated above, apply here as well. Additionally, a person bearing the following relationship to an otherwise qualified individual would also qualify where the sale or exchange is for health reasons in order to facilitate the care of the sick family member:

Example 17. Cassy was employed by The Rhody Corporation in its Providence office. Cassy purchased a house in February 2001 that was 35 miles from her office. In May 2002, Cassy began a temporary assignment at Rhody’s Boston office, which was 72 miles from Cassy’s house, and she moved out of her house. In June 2004, Cassy is assigned to work in Rhody’s London office and, as a result, she sells her house in August 2004. The sale of the house does not meet the safe harbor provisions because the Boston office is not 50 miles farther from Cassy’s house than the Providence office. Furthermore, the sale does not satisfy the safe harbor because Cassy is not using the house as her principal residence when she moves to London. Cassy is entitled to claim a reduced maximum exclusion under IRC section 121(c)(2), however, because the facts and circumstances demonstrate that the primary reason for the sale is the change in her place of employment.

Example 18. In July 2002, Deborah bought a condominium that was five miles from her place of employment and used it as her principal residence. In February 2003, Deborah obtained a job located 51 miles from her condominium. Deborah, an emergency medicine physician, may be called in to work unscheduled hours and must be able to arrive quickly. Deborah sold her condominium and bought a townhouse four miles from her new place of employment. Deborah’s new place of employment is only 46 miles farther from the condominium than is Deborah’s former place of employment, so the sale does not meet the safe harbor provisions. Deborah may claim a reduced maximum exclusion, however, because the facts and circumstances demonstrate that the primary reason for the sale is the change in her place of employment.

Example 19. Hope and Walter purchased a house in 2002 that they used as their principal residence. Their son suffered from a chronic illness that required regular medical care. Their doctor recommended that their son begin a new treatment at a medical facility 100 miles away. In 2003, Hope and Walter sold their house, to be closer to the medical facility. Under the facts and circumstances, the primary reason for the sale is to facilitate the treatment of their son’s chronic illness. Therefore, Hope and Walter may claim a reduced maximum exclusion.

Example 20. Bernard bought a condominium in 2003 and used it as his principal residence. Three months after Bernard moved into the condominium, the condominium association decided to replace the building’s roof and heating system. Six months later, Bernard’s monthly condominium fee doubled. Because of the higher condominium fee, in 2004 Bernard sells the condominium. The safe harbor provisions do not apply, but under the facts and circumstances, the primary reason for the sale is unforeseen circumstances, and Bernard may claim a reduced maximum exclusion.

Example 21. In 2003, Charlton bought a house on a heavily trafficked road, that he used as his principal residence. In 2004, Charlton sells the property because the traffic is more disturbing than he expected. Charlton is not entitled to claim a reduced maximum exclusion under the safe harbor because, under the facts and circumstances, the traffic is not an unforeseen circumstance.

Example 22. In 2003, Donna and her fiancé Evan bought a house and used it as their principal residence. In 2004, Donna and Evan cancel their wedding plans and Evan moves out. Because Donna cannot afford to make the monthly mortgage payments alone, Donna and Evan sell the house in 2004. The safe harbor provisions do not apply, but because the primary reason for the sale is unforeseen circumstances, Donna and Evan are each entitled to claim a reduced maximum exclusion.

Retroactive Application and Audit Protection

Taxpayers qualifying under the temporary regulations that sold or exchanged a home on or after May 7, 1997, and before December 24, 2002, may elect to retroactively apply all of the IRC section 121 provisions to those years for which the period for filing for a refund has not expired. An amended return on Form 1040X for the taxable year of the sale or exchange should be filed, and the gain should not be included in the taxpayer’s gross income. The IRS has stated that it will not challenge a taxpayer’s position that a sale or exchange of a principal residence during this period qualifies for the reduced maximum exclusion if the taxpayer has made a reasonable, good-faith effort to comply with the requirements of IRC section 121(c) and if the sale or exchange otherwise qualifies under IRC section 121.

Lisa Church JD, CPA, is an assistant professor at the school for management and technology at Rhode Island College in Providence, R.I.
Joseph P. Matoney, PhD, CPA, and Mark Higgins, PhD, CPA, are professors at the college of business at the University of Rhode Island, Kingston, R.I.