Exclusion of Gain from Sale of Principal Residence

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	Home Sale Exclusion Personal Finance Advisor by Deloitte & Touche OnLine April 27, 1998

How the one-time exclusion of gain from sale of a principal residence works.

Many residential real estate transactions occur during the spring months. The Taxpayer Relief Act of 1997 included a lucrative exclusion for individual taxpayers who have realized a gain from the sale of their principal residence. The new law applies to sales occurring after May 6, 1997, and replaces the old gain rollover rule (deferral of gain), as well as the $125,000 "once in a lifetime" exclusion of gain from the sale of a principal residence.

The gain or loss on the sale of a home is generally based on the selling price less expenses of the sale and the taxpayer’s adjusted basis in the home. Adjusted basis is defined as the original cost plus improvements minus any deferred gain from previous rollovers.

Exclusion Amounts: All or part of the gain from the sale may be excluded from income if certain ownership and use tests are met. The exclusion is allowed once every two years, and the maximum exclusion is $500,000 for married persons filing a joint return ($250,000 for single taxpayers). Any gain in excess of the exclusion will be taxed at the capital gains tax rates. To be eligible for the exclusion, the seller must have owned and used the home as a principal residence for at least two years (730 days) out of the previous five years.

Principal Residence: A house, houseboat, mobile home, cooperative apartment, or condominium can be a principal residence. To qualify for the gain exclusion, the taxpayer must satisfy both the ownership and use requirements -- own the principal residence for at least two of the five years before the sale or exchange, and live in the home for at least two of the five years. The two years need not be continuous (that is, the use requirement would be met if the taxpayer lived in the home the first and fourth years).

Example: A single taxpayer owned and lived in his/her principal residence for the last five years. IN 1998, the taxpayer sold the home and realized a $300,000 gain. The full amount of the gain exclusion applies -- $250,000 of the gain would not be subject to the federal tax.

The remaining $50,000 gain is subject to the new capital gains tax rates (20 percent for property held more than 18 months). After two years, the single taxpayer can exclude up to $250,000 of the gain on the sale of another residence.

For married taxpayers to qualify for the full $500,000 exclusion, both spouses must live in the home for at least two of the five years preceding the sale or exchange, and neither could have used the exclusion during the previous two years. Only one spouse, however, must meet the two-year ownership test. If only one spouse meets both the ownership and use requirements, the $250,000 exclusion for a single taxpayer is available for the qualifying spouse (even if the other spouse utilized the exemption within the past two years).

There are several exceptions to the two-year ownership and use rules:

If at any time during the five-year period, the taxpayer became physically or mentally unable to care for himself/herself, the use test will be satisfied if the taxpayer lived in the residence for more than one year.
If a gain on the sale of a previous home was deferred and rolled over to the current residence, or if the previous residence was destroyed or condemned, the period the taxpayer owned and lived in the previous home is considered in the ownership and use tests (that is, the holding period of the previous home carries over to the holding period of the residence currently being sold).
In the case of the death of a spouse, a home transfer from a spouse (or former spouse) to an individual, or the use of the home by a non-owner former spouse under a divorce or separation agreement, each spouse is considered to have owned and used the property as a principal residence during any period his/her spouse (or former spouse) owned and/or used the home.

Reduced Exclusion: If the principal residence is owned and used for less than two years, a reduced gain exclusion may be available if (1) the taxpayer owned the home on August 5, 1997, and sold it before August 5, 1999 (regardless of the reason for sale), or (2) the home had to be sold because of a change in the taxpayer’s health, place of employment, or some other unforeseen circumstance. The reduced exclusion calculation is generally based on the lesser of the days used or owned, divided by 730 days.

Example: A single taxpayer purchased his/her first residence on April 1, 1997, sold the home one year later, and recognized a gain of $150,000. The taxpayer can exclude up to $125,000 of the gain [$250,000 times (365 days/730 days)].

The $250,000 gain in excess of the $125,000 allowable exclusion will be taxed using the capital gains tax rates applicable to the holding period of the property (28% for a 12- to 18-month holding period).

Rental of Residence before Sale: Provided the ownership and use tests are met, renting the property may not jeopardize the gain exclusion. A taxpayer will qualify for the exclusion if he/she owned and used a home for two years, and converted the residence to rental property for up to three years. The exclusion, however, is not available for any depreciation recapture (depreciation allowed or allowable after May 6, 1997, is recaptured and taxed at 25%).

Home Office Deduction: If a portion of the principal residence is used as a home office (that is, the taxpayer has taken a home office deduction on his/her tax return), the exclusion may not apply to the portion of gain attributable to the home office. If no home office deduction was claimed for at least two of the previous five years, the taxpayer will likely qualify for the full exclusion (provided ownership and use tests are satisfied). As with property that has been rented, the gain exclusion is not available for recapture of depreciation taken on a home office.

These are some thoughts to consider about a gain from the sale of a principal residence. Your financial and tax advisors can provide more information and should be consulted before any action is taken.