By Anthony E. Cooch, Jr., CPA, Esq.
Internal Revenue Code (IRC) Section 121 allows for the exclusion of capital gains upon the sale of a “principal residence.” Individuals who qualify for this exclusion can exclude up to $250,000 of taxable gain if single, or $500,000 if married and filing jointly.
In order to qualify for the exclusion, several tests must be met.
• First, the real estate sold must be the taxpayer’s principal residence.
• Second, the taxpayer must have used the home as its principal residence for any two out of the last five years.
What is a principal residence?
A taxpayer’s principal residence is where that taxpayer lives. If the taxpayer lives in many places during the year or lives in two different homes, the analysis becomes more complex. As of the date of this writing, there are no set rules that classify property as a principal residence. Such a determination is made on a case-by-case basis by examining all of the facts.
Factors used to determine the taxpayer’s principal residence are:
• Where the taxpayer works
• Where the taxpayer’s family lives
• Address listed on official documents such as tax returns, driver’s license, automobile registration, and voter registration card
• Taxpayer’s mailing address for bills and other correspondence
• Location of the taxpayer’s bank
• Location of religious organizations and other clubs with which the taxpayer is affiliated
The “two out of the last five year” rule
To qualify for the exclusion, the taxpayer must also have owned and used the home as his or her principal residence for any two out of the last five years. For IRS purposes, two years is defined as 24 months or 730 days.
The computation is fairly straightforward: count the number of days the taxpayer used the property during the last five years, and if it is equal to or greater than 730 days, the property will satisfy the requirement.
Frequency of the exclusion
Even if the taxpayer meets both tests, one further restriction applies – taxpayers are eligible to exclude gains only once every two years.
Example: Tom uses Home A as his principal residence in 1998 and 1999. In 2000, he acquires Home B and uses it as his principal residence in 2000 and 2001. In 2002 he sells Home A and in 2003 he sells Home B. Even though Tom meets the ownership and use requirements, he cannot exclude the gain from the sale of Home B because it was sold within two years of taking the exclusion for the sale of Home A.
Other notes
The IRS has taken into account the fact that people often move for unexpected reasons and that people often own property with a friend or other unrelated person. When either of these characteristics exists, gains can still be excluded.
Moving for unexpected reasons
If the taxpayer sells his or her principal residence because of a change in the place of employment, health, or unforeseen circumstances, gains can still be excluded but at a reduced amount. When such events occur, the taxpayer will be allowed to exclude a pro-rated amount of gain.
Joint ownership
Taxpayers who own a principal residence jointly with another person can still qualify for the exclusion. As long as the other tests are met, each joint owner can exclude $250,000 of the gain attributable to that taxpayer’s interest in the property.
Example: Tom and Rick jointly own a house, each owning 50%. They sell the home for a gain of $100,000. Both individuals meet all the requirements for exclusion. Tom and Rick can both exclude the entire amount of gain of $50,000 attributable to their interest, because it is less than their allowable exclusion amount of $250,000.
Conclusion
IRC Section 121 provides taxpayers with a way to save a significant amount of money when selling their homes. By following simple rules, taxpayers can exclude up to $500,000 of gains from tax.
