One of the most important tax giveaways is the main residency rules for capital gains on the sale of your home. So large is the primary residence tax exclusion that even married couples filing jointly benefit as much, if not more, than single taxpayers. Now, some people may argue that there have been, are, and will be greater gifts, but there isn’t much better than the simplicity of this rule. The basics are immensely easy to understand: you own a home, live in it for at least two years, sell it, and pay no tax on the gain. Gone are the days when the young homeowner (not wanting to sell and upgrade) had to keep every receipt for every upgrade, every repair, every minor item purchased at the hardware store. If he’s lived in his own house for two years, he probably doesn’t have to worry.
Of course, there are some technicalities associated with the general rule. They’re pretty simple, so I’ll first point out the main ones:
o If you are single, your capital gains exclusion is limited to $250,000.00
o If you are married, your capital gains exclusion is limited to $500,000.00
o You must own the home and it must be your “primary residence” for two of the previous five years
What is your “primary residence”? Basically, it is a house that you personally live in for most of the year. If you have a house in Palm Beach and one in Lake Tahoe and you spend 8 months of the year in the Tahoe house, then that is your primary residence. But, keep in mind part 2 of 5 of the rule. Let’s say next year you spend 7 months in the Palm Beach house. So the Palm Beach house is his primary that year. Do you see where I’m going with this? You can principal more than one household at a time during a five-year period as long as each one is your principal home for at least two years during that five-year period. Temporary absences are also counted as periods of use, even if you rent the property during those absences (but talk to your accountant about recouping any rental depreciation).
Now, don’t let the five-year requirement fool you: it only takes two years to achieve tax exclusion. The five year portion is a bonus, allowing you some freedom. You do not have to personally use the home as your primary residence for two consecutive years or during the two years immediately preceding the sale, you only have to use it as your primary residence for two of the preceding five years. But, it’s also a limitation, you can’t live in a house for two years and then rent it for four years and then get the exclusion. You can live in it for two years and then rent it out for three years and then sell it (as long as it is sold within five years of when you first lived in it as your primary residence).
Also, keep in mind that married couples do not have to live together. As long as one spouse lives in the primary residence for the two years, the couple can take advantage of the $500,000.00 exclusion. But, they cannot primary two houses at the same time and obtain the exclusion of $500,000.00 in both. If they live apart during the two-year period and each sells her principal property, then each is limited to the individual taxpayer exclusion of $250,000.00 for each home.
If you have a home or rental office as part of your primary residence or run a business on a portion of your property, your ability to maximize your capital gains exclusion depends largely on whether the home office, business, or rental was part of your home (in the same living unit) or in a separate part of your property (a separate building or apartment). If the business use of your home was contained within your dwelling unit, you will need to recover any depreciation taken for that part of the home after the sale. But you won’t lose any of the allowed capital gains exclusions ($250,000.00 for single taxpayers and $500,000.00 for married filing jointly). If the business use of your home was not part of your dwelling unit, then you must bifurcate the sale by allocating the basis of ownership and the amount realized in your sale between the commercial or rental part and the part used as a home.
Remember, only one home can be sold in any two-year period, unless you and your spouse are living apart, and even then each can only take the single-payer exclusion of up to $250,000.00. But what if you need to sell a home you haven’t lived in for the full two years? The IRS tells us that under special circumstances, you can sell a home before it’s two years old and still get a prorated exclusion. An example of a prorated exclusion is, for example, if you are a single taxpayer and you have to sell your primary residence for a qualified reason after living in it for only one year, you could exclude up to $125,000.00. In other words, you lived in the home 50% of the time required for you to take the 50% allowable exclusion. The special circumstances that qualify you for this safe harbor and allow you to take the prorated exclusion have to do with health (yours and certain qualified people, such as close relatives), job change, or what the IRS calls “unforeseen circumstances.” (examples include death, natural or man-made disasters, multiple births from the same pregnancy, divorce) These circumstances must also cause you to sell your home. Factors used by the IRS to determine causation include:
o Your sale and the circumstances behind it were closed on time,
o The circumstances that caused your sale occurred during the time you owned and used the property as your primary home,
o The circumstances that caused your sale were not reasonably foreseeable when you began using the property as your primary home,
o Your financial ability to support your home has materially changed, and
or The suitability of your property as a home has materially changed.
1031 Exchanges and the Principal Residence Rule
What happens if you make a similar tax-deferred exchange (also known as a 1031 exchange) of a rental property or other property that you have as an investment, and then decide to live in the property you bought? It is crucial to your 1031 exchange that both the property sold and the property purchased are held as an investment. Purchased property must go through a holding period before being resold or converted into non-investment property. That holding period should be one year and one day to avoid auditing. After you have met the “investment hold” requirement, eg by renting the property if it is a rental property, what then? Well, you could sell the property and pay your taxes on that sale and all previous sales that were perhaps in a series of exchanges or exchange and defer the tax one more time, OR you could live in the house as your primary residence. If you’ve had a series of gains that you’ve deferred, here’s a way to extinguish your tax debt forever: all you have to do is move into your investment property once the holding period is over for it to qualify as an investment. .
Getting the primary residence exclusion for a property that was 1031 owned is not as easy as the simpler primary residence rules above, but it allows you to take advantage of two loopholes at once! The main difference when you primarily reside in a 1031 exchanged property is that you actually have to hold the property for 5 years. The five year part here is a substantive rule, you can’t sell after only 2 years of ownership like you can if it was simply your primary residence in a home that wasn’t traded. But that first year that you had to keep the house to invest goes toward the five-year calculation. So, you rent it for two years and live in it for three, or vice versa, as long as you start everything with a one-year rental period and live in it for two of the remaining four years.
In this way, you can exclude up to a total of $500,000.00 of gain (if you are married filing jointly or $250,000.00 of gain if you are a single taxpayer) from the combined gain from the sale of the home you ended up living in. as his principal residence, and any earnings he had 1031 previously exchanged. For example, let’s say you bought a duplex in May 2000 for $150,000.00 and then in June 2001 1031 you traded the duplex (now worth $200,000.00) for a commercial building worth $200,000.00 (thus deferring $50,000.00 of profit). A few years later, the commercial building is worth $300,000.00 and you make another trade, this time for a nice single-family home worth $350,000.00 (you have to put down an additional $50,000.00 to complete the purchase). You have now deferred a total of $150,000.00 in winnings. Let’s say you then choose to rent the house for the first two years you own it, and then decide to move into the house. He then lives in the house for three years, at which time it is now worth $700,000.00, and sells it for this amount. You and your spouse have now effectively eliminated not only the $350,000.00 gain from the sale of your primary residence, but also the $150,000.00 prior gain.