The home sale exclusion presents a wide range of planning opportunities for the elderly. To understand the planning opportunities presented, and the possibly significant tax costs that might be incurred, an overview of these rules is presented.
An exclusion is available, without regard to the client’s age, up to $250,000 ($500,000 on a joint return) of gain on the sale of a principal residence. To qualify for this treatment a number of requirements must be met:
The house sold must have qualified as the client’s principal residence for at least two years (732 days) of the five years prior to the sale. Vacations or seasonal absences (e.g., a month in Florida during the winter) continue to count as periods of use (but see new restrictions discussed below). The ownership and use tests do not have to be met concurrently, so the client can own the home at a time that they did not live in the home and still qualify so long as both tests are independently met. If a client lives in a licensed care facility, such as a nursing home, because of incapacity, the period of time in such a facility counts as use of the home so long as the client continues to own the home.
To add further flexibility, if the client doesn’t meet the full two year test, he or she may benefit from a portion of the maximum exclusion if he or she had to move because of a job change, health problem, or other qualifying unforeseen circumstance. If the new place of employment for the client is at least 50 miles further from the house sold then was the former location of employment, then the change of employment will be deemed to be the principal reason for the sale and relief will be granted. If the reason the home is sold is to obtain, facilitate, and provide for the diagnosis, cure or treatment of an illness, disease, or injury for the client or a spouse (any qualified individual) that will entitle the client to relief. Efforts should be made to document the medical necessity of the sale and move. Unforeseen circumstances can include a fire or other involuntary conversion, unemployment that makes the home unaffordable, terrorism, etc. If these opportunities do not cover the client’s situation, the IRS will consider other factors.
If the client only qualifies for a partial exclusion under the above relief provisions, the amount of home sale exclusion is calculated as follows:
Maximum Exclusion ($250,000 or $500,000)
Shortest of: Time owned property as principal residence during the five year period; or time used the property as principle residence during the five year period; or the period from the date of the last prior sale to which the exclusion applied to the current sale.
If the residence was partially used for personal purposes as a principal residence, but partially used for business purposes (rental or home office) the full exclusion may not be available. For example, a client had a horse stable and pasture land adjacent to her residence which was used for commercial purposes. The proceeds from sale would have to be allocated between the residential and commercial portions, and only the amounts allocable to the residential portion could qualify for the exclusion. To the extent that depreciation was claimed on the property after May 6, 1997, the exclusion will not be available. This means that depreciation prior to such date will not have an adverse impact. See Form 4797.
The maximum gain that can be excluded is $250,000 for a single client or $500,000 for a married couple filing a joint tax return. If your client’s gain on the sale of his house exceeds the exclusion of $250,000 ($500,000 on a joint return), then a capital gains tax cost will be incurred. This is discussed below.
To use the higher $500,000 exclusion one of the spouses had to meet the ownership test of owning the house for at least two of the preceding five years. Both spouses had to use the house as a principal residence during at least two of the five years preceding the sale. In addition, neither spouse can be ineligible for the home exclusion benefit from having sold or exchanged a residence within the prior two years (see below).
A special rule applies for a deceased spouse: The surviving spouse is treated as if she had owned and used the residence for the period that the deceased spouse had. See below.
This valuable exclusion can be used once every two years. Therefore, if the client sold a prior house and used this exclusion, less than two years prior to the sale of the client’s current house, the gain on the sale of the current house will be taxable. To qualify for the house sale exclusion, the client could not have excluded gain under this provision within the two year period preceding the sale intended to qualify.
Special Restriction for Vacation and Second Homes. Taxpayers had taken considerable advantage of the home sale rules to exclude gain on vacation homes. Planning for the home sale exclusion could have, with a bit of planning, extended to vacation homes.
Example. Assume that your clients own two residences. The clients could sell the first house and avoid gain, then move into the vacation house, making it their personal residence for two years. Thereafter, they could sell this second residence and exclude up to $250,000 ($500,000 on a joint return) of gain on it as well. This planning technique had been particularly useful for senior clients looking to downsize to a smaller house, or to move from their primary residence to their smaller vacation home.
The government became aware of this aggressive planning and restricted the benefits involved in the Housing Assistance Tax Act of 2008. Now, if a client sells or exchanges a personal residence after December 31, 2008, the home sale exclusion will not apply to the extent gain from the sale or exchange is allocable to periods of nonqualified use, such as the rental of the property or its use as a vacation home. Non-qualified use is defined in new Code Section 121(b)(4). These types of non-qualified uses prior to 2009 are ignored. The Housing Assistance Tax Act of 2008.
If your clients are married and file a joint income tax return for the year of sale they can exclude up to $500,000 of gain if the requirements discussed above are met. One of the requirements to qualify for the higher $500,000 exclusion is that a husband and wife had to file a joint return for the year the house was sold. In the year your client’s spouse dies the client can still file a joint return. However, the year after that, the client is precluded from filing a joint return with his or her deceased spouse. So, if your client sold his or her home in a year after the year his or her spouse died, the client would not qualify to file a joint return so that the maximum home sale exclusion would be only $250,000. Beginning January 1, 2008 your client who qualifies as a surviving spouse, if still single, may sell his or her house not later than two years after his or her spouse's death, and if the other requirements for the $500,000 exclusion are met, can qualify for the larger exclusion. IRC Sec. 121(b)(2)(A) and 121(b)(4), as amended by Mortgage Forgiveness Debt Relief Act, Sec. 7(a).
If your client’s spouse died, and the client has not remarried, the ownership and use of the house for purposes of qualifying for the home sale exclusion, will include the use and ownership of the deceased spouse. IRC Sec. 121(d)(2).
It is important to note that your client cannot afford to ignore record keeping. Although the purported benefit of the home sale exclusion is that clients can ignore the burdensome record keeping necessary to demonstrate tax basis in their houses, the technical requirements of qualification (e.g., if the client may face a divorce, relocation because of health issues, or another event forcing an untimely sale), make record keeping essential. Records will also prove essential in the event of fire, theft, or other casualty loss. Therefore, clients should be encouraged to maintain records of all improvements, etc.
With such a tremendous tax exclusion involved, the IRS pays attention to the facts and circumstances necessary to support the treatment of any property as a qualifying principal residence. The recent restriction on excluding gain attributable to periods of non-qualified use attests to the attention this tax benefit is given. Suggest prior to any house closing that the client review the qualifications for the home sale exclusion rules with his accountant and document the basis for qualifying, especially if one of the relief provisions noted above is going to be relied upon.
The $250,000/$500,000 tax exclusion is available every two years. From a pure tax planning strategy, what this means is that any time the clients are coming close to realizing the maximum amount of excluded gain, they could sell their house, claim their exclusion, and then purchase a new house. From a tax perspective, rather than owning one house for 20 years, because a modest annual inflation alone could push the client’s gain beyond that permitted, selling and reinvesting may generate a better result.
The new rules governing house sales will enable many clients residing in their houses to free up the investment equity in their houses by selling without incurring tax cost. Senior clients can scale down house ownership, market conditions permitting, since they will no longer be required to reinvest to avoid tax. These funds can be used to cover other costs of retirement. Even if a tax has to be incurred because profits exceed the $250,000 or $500,000 limits, the capital gains tax cost may not be sufficiently significant to dissuade the client from selling and cashing out their house investments. See below. Also, be cautious of new tax legislation affecting this type of planning.
The divorce of seniors is growing rapidly, so the issues of the home sale exclusion for seniors divorcing is likely to grow as well. If the senior client is involved in a divorce, a host of further complications will affect planning. If one spouse is granted exclusive use of the residence pursuant to a separation agreement, divorce decree, or other instrument, that use will be credited to the second spouse for purposes of meeting the use and ownership requirements.
POINTER: Caution should be exercised to be certain that the usage is mandated by a qualifying agreement; if not, it will not be credited to the spouse not residing in the house. The timing of each spouse’s use and ownership should be considered to assure the maximum qualification for the exclusion.
It may be advantageous to delay the divorce, or the common filing of separate tax returns, to assure that the full $500,000 exclusion is available. In the context of a divorce settlement, if the house is transferred to one spouse, that transferee spouse may treat the house as if he or she had owned it during the period it was owned by the transferor spouse.
Subscribe to our email list to receive information on consumer webcasts and blogs, for practical legal information in simple English, delivered to your inbox. For more professional driven information, please visit Shenkman Law to subscribe.