The sale of a principal
residence is generally not a taxable event, unless the taxpayer:
- Has a gain and does not qualify to exclude it
all
- Has a gain and elects not to exclude it
- Received a Form 1099-S for the sale
Typically, a single taxpayer
can exclude from their income up to $250,000 of gain from the sale of a
personal residence if the following criteria are met (Internal Revenue Code [IRC]
Sec. 121):
- Ownership and use: the individual must have
owned and used the home as a principal residence for at least two out of the
five years prior to the sale (the two years do not have to be consecutive).
- Frequency limitation: The exclusion applies to
only one sale every two years.
Married couples filing a
joint return can exclude up to $500,000 of gain under the following conditions:
- Ownership: either or both spouse(s) must have
owned the residence for at least two out of the five years prior to the sale.
- Use: both spouses must have used the residence
as their principal residence for at least two out of the five years prior to
the sale.
- Frequency limitation: during the two-year period
ending on the date of the sale, neither spouse excluded gain from the sale of
another home.
Use and frequency
conditions
It is worth noting that the use
and frequency tests must be met by both spouses in order for them to qualify
for the full $500,000 exclusion, while only one of the two must meet the
ownership test. If both spouses do not meet the use and frequency tests, the
allowable exclusion is limited to the sum of the amounts that each spouse would
be qualified to exclude if they had not been married. Each spouse is treated as
owning the property for the period of time that either spouse owned the
property.
For example, consider the
following case: On January 1, 2010, Cindy purchased a home for $250,000. On
September 10, 2012, Cindy and George were married. On January 1, 2013, they
decided to sell their home for $600,000. In this instance, because George does
not meet the use test, only Cindy can exclude $250,000 of gain. The additional
$100,000 will be taxable.
If we change the scenario so
that the house was instead sold on September 12, 2014, then they would meet all
the requirements to exclude the entire gain.
If each spouse sells a home
prior to marriage and each spouse meets the ownership, use, and frequency tests,
then each spouse may exclude up to $250,000 of gain on his/her own home.
For example, Cindy and George
both sold homes in 2019, prior to their marriage and purchase of their new
home. They had both owned and lived in their respective homes for more than two
out of the last five years. Neither Cindy nor George had excluded a principal
residence gain in the prior two years. As long as the gain on the sale of each
of their individual residences was below $250,000, there would be no taxable
event. If, however, Cindy had a gain of $300,000 and George had a gain of
$150,000, George would not be allowed to exclude the $50,000 excess gain from
Cindy’s sale of a personal residence.
The $500,000 gain exclusion
amount that applies to taxpayers filing a joint return will also apply to
unmarried surviving spouses if the sale occurs within two years of the death of
their spouse. To qualify for this, each of the following conditions must be met
(IRC Sec. 121[b][4]):
- Either the surviving spouse or the deceased
spouse must meet the two-year ownership requirement for the residence
immediately before the spouse dies.
- Both spouses must meet the two-year use
requirement immediately before the spouse dies.
- Neither of the spouses may have used the
exclusion during the past two years.
Note that this rule will not
apply if the surviving spouse remarries before a sale or exchange of the
residence within the two-year period.
Reduced exclusion rules
Taxpayers who do not meet the
two-year ownership and use tests or who use the Section 121 exclusion more than
once in a two-year period may qualify for a reduced exclusion. A reduced
exclusion is available if the primary reason the taxpayer sold a primary residence
was one of the following:
- A change in place of employment
- Health
- Unforeseen circumstances
These reduced exclusion
rules will next be described in greater detail.
Change in place of
employment
A reduced exclusion will
apply if the taxpayer’s primary reason for the sale is a change in the location
of a qualified individual’s employment. “Qualified individuals” are defined as
the following:
- The taxpayer or taxpayer’s spouse
- A co-owner of the home
- A person whose main home is the same as the
taxpayer’s
“Employment” includes the
state of work with a new employer or a new location of the same employer. It
also includes the start or continuation of self-employment.
A change in place of
employment is considered to be the primary reason the taxpayer sold the home if
both of the following are true:
- The change occurred during the period the
taxpayer owned and used the property as a main home.
- The new place of employment is at least 50 miles
farther from the taxpayer’s home than was the former place of employment. If there
was no former place of employment, the new place of employment must be at least
50 miles from the home sold.
Health
The sale is due to health if
the primary reason for the sale is to obtain, provide, or facilitate the
diagnosis, cure, mitigation, or treatment of a disease, illness, or injury of a
qualified individual. The sale of a home is not because of health if the sale
merely benefits a qualified individual’s general health or well-being.
Here, qualified individuals
include, in addition to the individuals listed in the section above, any of the
following:
- Parent, grandparent, stepmother, or stepfather
- Child, grandchild, stepchild, or adopted child
- Brother, sister, stepbrother, stepsister,
half-brother, or half-sister
- Mother-in-law, father-in-law, brother-in-law,
sister-in-law, son-in-law, or daughter-in-law
- Uncle, aunt, nephew, niece, or cousin
Unforeseen
circumstances
Reduced exclusion rules apply
if the primary reason for the sale is the occurrence of an event the taxpayer
did not anticipate before purchasing and occupying the residence. A taxpayer
does not qualify for a reduced exclusion if the primary reason for the sale is
a preference for a different home or an improvement in financial circumstances.
The following events qualify
as unforeseen circumstances:
- An involuntary conversion of the home
- Natural or man-made disasters or acts of war or
terrorism resulting in a casualty to the home
- Any of the following, applying to qualified
individuals (as defined under “Change in place of employment”):
- Death
- Loss
of job resulting in being eligible for unemployment compensation
- A
change in employment or self-employment status that results in the taxpayer’s
inability to pay reasonable basic living expenses
- Divorce
or legal separation
- Multiple births resulting from the same pregnancy
event the Internal Revenue Service (IRS) determines to be an unforeseen
circumstance
Converting a Principal Residence to
Rental Use
Homeowners may still qualify
for gain exclusion under IRC Section 121 even if the home is converted to
rental use.
If the rental portion of the
taxpayer’s home was used as a personal residence for two or more of the five
years before the sale, the taxpayer can exclude the gain on the entire home
(except for any depreciation allowed or allowable after May 6, 1997).
For example, Susan purchased
her home in April 2010 and used the entire home as her principal residence. In
May 2018, Susan moved out but was not able to sell the residence right away. Susan
decided to rent the home until she could sell it. Susan eventually sold the
home in January 2019. Because Susan owned and used the home as a principal
residence for at least two out of the five years before the sale, she would be
able to exclude up to $250,000 of gain on the sale. However, she would not be
able to exclude the part of the gain equal to the depreciation allowed while
renting the house.
