Sale of a Principal Residence
The sale of a principal residence is probably the most significant tax transaction most taxpayers will encounter. When a residence is sold, the rules for determining the potential gain - its deferral or exclusion by persons aged 55 or older - are often interrelated and complex. When a portion of the principal residence is also used for a business or as a rental unit, allocations between the business and non-business portion of the residence must be made. If a married couple owns the residence, their marital status at the time of purchase and sale may cause allocation problems as well. With the elimination of the capital gains deduction for individuals commencing in 1988, the provisions deferring tax on the sale of a residence and the exclusion of gain by persons aged 55 have increased in importance.
Computing Gain or Loss: General Principles
When property is sold, Internal Revenue Code Sec. 1001 determines the amount of gain or loss realized and recognized for tax purposes. The computation for gain is the amount realized minus the adjusted basis; the computation for loss is the adjusted basis minus the amount realized.
Amount Realized
The amount realized is the sum of money and the fair market value of other property received by the seller, minus selling expenses.
Adjusted Basis
The adjusted basis measures the "tax cost" of the property owned by the seller. It is generally the cost paid by the taxpayer, plus the costs of any capital expenditures or improvements made to the property, minus any depreciation deductions taken. The cost is generally the amount paid for the property, including any indebtedness which the taxpayer assumes as part of the original purchase.
Amount Recognized
The amount recognized is the "profit or loss" on the transaction. The entire amount of the gain or loss realized will be recognized in the year of sale and treated as gross income (or as a deduction from gross income if there is a loss permitted under the Code), absent a specific non-recognition or exclusion provision.
Section1034 - Sale of a Principal Residence: Rollover of Gain (Old tax law)
Sec. 1034 is a non-recognition provision which involves the replacement of a principal residence ("old residence") with another principal residence ("new residence"). If Sec. 1034 applies, the taxpayer rolls over the gain from the sale of the old residence into a new residence, and this process will continue through successive sales until a sale occurs in which Sec. 1034 does not apply.
Under Sec. 1034, if the taxpayer: (1) sells the old residence and acquires a new residence; and (2) the acquisition of the new residence occurs within 2 years of the sale of the old residence (NOTE: the new residence can be acquired up to 2 years prior to the sale of the old residence); then (3) Sec. 1034 will apply to the extent the cost of the new residence exceeds the adjusted sales price (discussed below) of the old residence. NOTE: The comparison is between the adjusted sales price of the old residence and the cost of the new residence.
NOTE: There is no tracing of proceeds from the sale of the old residence to the acquisition of the new residence. The old residence could be sold on an installment basis and the new residence could be purchased for cash from savings or from borrowed funds.
Sec. 1034 contains a limitation to prevent the rapid purchase and sales of residences under the provision: There must be at least 2 years between each sale of a residence.
Section 1034—Rollover of Gain from the Sale of a Primary Residence (Repealed)
Section 1034 of the Internal Revenue Code ("1034 Exchange") was repealed and replaced by Section 121 of the Internal Revenue Code. However, it is important to understand what Section 1034 was all about, what changed with the repeal of this Section and what the differences are between the old and new laws.
Section 1034 of the Internal Revenue Code allowed an owner of real property that was used as his or her primary residence to sell or otherwise dispose of the primary residence and defer 100% of his or her capital gain tax liability by acquiring another primary residence of equal or greater value.
Qualified Intermediaries were not required for Section 1034 exchange transactions.
Section 121—Exclusion of Capital Gain on the Sale of Primary Residence (New law)
Due to the recent housing stimulus package, tax-free gains from the exclusion of a primary residence will now be more limited. (1/29/2009)
The Taxpayer Relief Act of 1997 repealed and replaced the tax deferral provisions contained within Section 1034 of the Internal Revenue Code with a capital gain exclusion provision pursuant to Section 121 of the Internal Revenue Code ("121 Exclusion").
Generally, a Taxpayer can sell real property held and used as his or her primary residence and exclude from gross income up to $250,000 in capital gain taxes if the Taxpayer is single and up to $500,000 in capital gain taxes if the Taxpayer is married and filing a joint income tax return. The Taxpayer is required to have lived in the real property as his or her primary residence for at least 24 months out of the last 60 months (two out of the last five years). The 24 months do not need to be consecutive and there are certain exceptions to the 24 month requirement when a change of employment, health, or other unforeseen circumstances has occurred.
Section 121 is effective for dispositions of real property held as a primary residence after May 7, 1997. Taxpayers can complete a 121 exclusion once every two (2) years.
Taxpayers should carefully monitor the amount of “built-up” capital gain in their primary residence and may want to seriously consider selling their primary residence before the capital gain tax liability exceeds the $250,000 or $500,000 limitation. The Taxpayer’s capital gain tax liability in excess of these exclusion limitations will be taxable. A sale of the primary residence would preserve the tax free exclusion of the capital gain and would allow the Taxpayer to acquire another primary residence and start all over again.
Special legal, tax and financial planning is needed in circumstances where a Taxpayer already has a significant capital gain tax liability in excess of the $250,000 or $500,000 exclusion limitation. For example, the primary residence could be converted to rental or investment property and then sold as part of a 1031 exchange after it has been rented for a sufficient amount of time in order to demonstrate the Investor’s intent to hold the property as rental or investment property. This would allow the Taxpayer to dispose of his or her primary residence, defer all of the capital gain tax liability, and diversify and allocate the capital gain tax liability proratably over a number of rental properties clearing the way for further financial, tax and estate planning opportunities.
There are special rules applicable to real property acquired initially as replacement property through a 1031 exchange transaction and then subsequently converted to the Taxpayer’s primary residence and sold pursuant to Section 121 of the Internal Revenue Code.
Effect of Marital Status on the Election
Once a taxpayer or his spouse has made an election to exclude the gain under Sec. 121 after July 28, 1978, neither party can make a subsequent election; there is only one election per married couple. If a married couple each owned their principal residence prior to their marriage, and if both residences were sold during the marriage, the Section 121 election applies to only one of the residences.
If each sold their respective residences prior to marriage and elected Sec. 121, a subsequent marriage would not cause any recapture of the Sec. 121 exclusion. Determination of marriage is made on the date of sale; however, an individual legally separated under a divorce or separate maintenance decree is not considered married. If a married couple divorces after one of the spouses made the election during the marriage, no further election under Sec. 121 is permitted to either spouse or to any future spouse.
Construction of a Replacement Residence
A replacement residence may be constructed, if it can be completed within the 2 year replacement period. If the deadline is not met, only costs incurred during the replacement period will qualify as costs of the new residence. Rehabilitating an existing house by remodeling a kitchen or adding rooms is also permitted.
What Is a Principal Residence
A principal residence is the home in which the taxpayer lives. It includes the conventional single family home, condominium or cooperative, a mobile home or a duplex. If the taxpayer has more than one residence, it is the home in which the taxpayer lives most of the time.
NOTE: Sec. 121 does not apply to the sale of a second residence, vacation homes or investment properties, even if the proceeds are invested in a principal residence.
The taxpayer must have an ownership interest in the residence; property in which the taxpayer resides, but in which legal title is held in the name of another family member (other than a spouse) or in trust (unless the taxpayer is considered the owner of the trust) will not qualify as a residence.
Property Used Partially For Business
If a residence is used partially for business or is rented out as an investment, the taxpayer can still claim the portion used for personal living as a residence. An allocation is made between residential and business use, and only the portion allocated to residential use will qualify under repealed Sec. 121.
Residence Temporarily Rented Out
The taxpayer does not have to live in the residence prior to its sale and may rent it out, provided the residence could not be sold due to circumstances beyond the taxpayer's control, for example: a declining real estate market, no mortgage money available, doubt as to whether a new job will work out, a temporary foreign assignment or adverse rent control laws. The focus is on whether the taxpayer intended to convert the residence into income producing property (investment property) rather than to sell it. This rule also applies if the taxpayer acquires a new residence prior to selling the old residence and temporarily rents it out.
Sale When Spouses Live Apart
If a married couple jointly acquired a residence and the residence is sold while they are living apart, Sec. 121 will apply, but each spouse is considered a 50% owner of the old residence.
Adjusted Sales Price
The adjusted sales price is the amount realized, minus fixing up expenses.
Amount realized: The amount realized is the sum of money (plus the fair market value of any property) received for the sale of the residence, minus selling expenses (such as commissions, advertising expenses, document preparation and legal services incurred in connection with the sale).
Fixing up expenses: Fixing up expenses are expenditures to prepare the old residence for sale such as painting, wall papering and repairs. The deduction is available if (1) the work was performed within 90 days from the date the sales contract for the old residence was signed, and (2) the expenses are paid no later than 30 days after the date of sale. The IRS has ruled that fixing up expenses are not deductible if the sales contract expires; a later sale will not cure the defect.
NOTE: Capital expenditures and improvements (generally expenditures which have a useful life over one year such as the installation of air conditioning, a new roof, furnace or fireplace) are not fixing up expenses, but are added to the basis of the old residence.
Cost and Basis of the New Residence
The cost of a new residence includes:
- the cash paid;
- any indebtedness to which the property is subject (mortgages, deeds of trust, land contracts);
- the face amount of any liabilities assumed by the purchaser;
- the cost of the land; and
- all capital expenditures attributable to construction, reconstruction, and improvement of the new residence if performed during the 2 year replacement period.
The basis in the new residence is its cost, based on repealed section 121.
Example:
Assume that in 1960 a taxpayer purchased a residence for $25,000 (for $5,000 in cash and a $20,000 mortgage) and made $15,000 worth of improvements. In 1987, the old residence was sold for $240,000, there were fixing up expenses of $5,000, commissions of $13,000. advertising costs of $1,000 and legal fees of $1,000. A new residence was purchased within 2 years for $210,000 (for $40,000 in cash and a $170,000 mortgage). Additionally, within the two year period, the kitchen in the new residence was completely remodeled for $20,000.
Amount Realized on Old Residence
- Sales price $240,000
- Less: Selling expenses
- Commissions $13,000
- Advertising 1,000
- Legal Fees 1,000
- Total Selling Expenses - 15,000
- Amount realized $225,000
Adjusted Sales Price
- Amount realized (line 3) $225,000
- Less: Fixing up expenses - 5,000
- Adjusted sales price $220,000
Gain Realized
- Amount realized (line 3) $225,000
- Less: Adjusted Basis
- Cost paid: cash $ 5,000
- Mortgage 20,000
- Improvements 15,000
- Total adjusted Basis: - 40,000
- Gain realized $185,000
- Less: Sec. 121 deduction: $250,000
Gain Recognized
11. Taxable gained recognized is 0.
Basis in New Residence
- Cost of new residence ($40,000 + $170,000 + $20,000) $230,000
- Basis in new residence $ 230,000
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