One of the most valuable assets a taxpayer will ever sell is their personal residence. Under IRC Section 121 of current tax law, a taxpayer can exclude up to $250,000 ($500,000 if married, filing jointly) of gain realized on the sale or exchange of a principal residence.
Any loss on a principal residence is deemed a personal loss and non-deductible.
What is a principal residence?
The determination whether a property is used as a taxpayer’s principal residence depends on a variety of factors. Some of these factors include:
- Principal place of abode for the taxpayer’s family members
- Address on the taxpayer’s driver’s license, automobile registration, and voter registration
- Mailing address for bills and correspondence
- Location of taxpayer’s banks
- Location of religious organizations and recreational clubs with which the taxpayer is affiliated
- Location of the taxpayer’s doctors
- Taxpayer’s place of employment
If a taxpayer uses more than one property as a residence, the property that checks the most boxes will likely be assessed as the primary residence. If a taxpayer alternates between two properties, the property used the majority of time during that year will be considered the principal residence for purposes of the IRC Section 121 exclusion. A houseboat, trailer, or apartment a taxpayer is entitled to occupy in a cooperative housing corporation (co-op) may also qualify as a principal residence.
How is gain or loss computed?
Gain (or loss) is computed based upon the selling price less expenses of the sale and the taxpayer’s adjusted basis in the residence. Adjusted basis is original cost plus the cost of improvements (not repairs) made to the residence and reduced by any depreciation claimed on the property.
Gain exclusion requirements
Taxpayer’s must meet three tests for the full gain exclusion to apply:
- Ownership – the taxpayer must have owned the residence for at least two years during the five years ending on the date of the sale or exchange. Tip – The measuring period is the actual time between sales, not taxable years.
- Use – the taxpayer must have occupied the residence as a principal residence for periods adding up to at least two years within the five-year period ending on the date of sale or exchange.
- One Sale in Two Years – the exclusion under Section 121 does not apply to any sale of a principal residence if, during the two-year period ending on the date of sale, the taxpayer sold their principal residence in which gain was excluded under section 121.
Example: A taxpayer sold a principal residence on March 1, 2016 and excluded the gain under Section 121. The taxpayer would not be eligible to claim the exclusion under Section 121 until April 2, 2018.
It is important to note The Tax Cuts and Jobs Act proposed increasing the length of ownership and use from two out of five years to five out of eight years. This was removed from the final version of the bill.
Property used partially as business and partially as principal residence
The IRS takes the position that the Section 121 exclusion is not available for any portion of the residence used for business purposes during the qualifying use period. Thus, if a portion of the property was used as a principal residence and a portion separate from the dwelling unit was used for non-residential purposes, only the gain allocable to the residential portion is excludable. However, no allocation is required if both the residential and nonresidential portions are within the same dwelling unit (commonly seen in home offices). It is important to note gain attributable to depreciation claimed after May 6, 1997 is not eligible for exclusion.
Example – Home office impact on gain exclusion
Jeff, an accountant, purchases a house in 2014. The house is a single unit, but Jeff has one room that is used exclusively for the accountant practice until the property is sold in 2017. Jeff claims depreciation of $3,000 attributable to the portion used as a home office. Upon the sale in 2017, Jeff realized a gain of $75,000.
Since Jeff’s home office is part of the dwelling, no allocation is required. However, Jeff must recognize $3,000 of the gain as unrecaptured Section 1250 gain (currently taxed at 25%), the depreciation claimed for the business portion of his home. The remaining $72,000 is excludable under the Section 121 exclusion.
Selling your principal residence? Get the advice you need for smart tax decisions
For more about how the sale of your principal residence can affect your tax situation, please contact me at [email protected] or (201) 655-7411.