Little-Known Rule Can Reduce Your Principal Residence Tax Break

With residential real estate markets surging, significant unrealized gains are piling up for many homeowners. That’s good news if you’re ready to sell, but what about the tax implications? Good question.

Thankfully, the federal income tax gain exclusion break for principal residence sales is still on the books, and it’s a potentially big tax-saving deal for prospective sellers.

But beware of the little-known rule that can reduce your allowable gain exclusion if you have not always used the property as your principal residence.

This article explains that unfavorable rule after first covering some necessary background information. Here goes.

Gain Exclusion Basics

Unmarried homeowners can potentially exclude principal residence gains up to $250,000, and married homeowners can potentially exclude up to $500,000.

You report the taxable part of any gain from selling your principal residence on Schedule D of Form 1040. Assuming no retroactive change to the contrary, the current maximum federal rate for long-term capital gains is 20 percent, or 23.8 percent if you owe the 3.8 percent net investment income tax (NIIT).

If part of your principal residence gain is taxable due to business or rental use of the property, complete IRS Form 4797, Sales of Business Property. On Form 4797, you’ll calculate how much of your gain is subject to the special 25 percent maximum federal income tax rate on gain attributable to depreciation deductions: so-called unrecaptured Section 1250 gain. You may also owe the 3.8 percent NIIT on all or part of the unrecaptured Section 1250 gain.

Pass the Ownership and Use Tests

To take full advantage of the principal residence gain exclusion break, you must pass both the ownership and use tests.

• To pass the ownership test, you must have owned the home for at least two years out of the five year period ending on the sale date.
• To pass the use test, you must have used the home as your principal residence for at least two years out of the five-year period ending on the sale date.
• If you’re married and filing jointly, you qualify for the bigger $500,000 joint-filer exclusion if (1) either you or your spouse pass the ownership test for the property, and (2) both you and your spouse pass the use test.

Avoid the Anti-Recycling Rule

The other big qualification rule for the home sale gain exclusion privilege goes like this: The exclusion is generally available only when you have not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot recycle the gain exclusion privilege until two years have passed since you last used it.

You can claim the larger $500,000 joint-filer exclusion only if neither you nor your spouse took advantage of it for an earlier sale within the two-year period. 

If one spouse claimed the exclusion within the two-year window but the other spouse did not, the exclusion is limited to $250,000.

The Conversion Problem

Once upon a time, you could convert a rental property or vacation home into your principal residence, occupy it for at least two years, sell it, and take full advantage of the home sale gain exclusion privilege of $250,000 for unmarried individuals or $500,000 for married joint-filing couples.

Unfortunately, legislation enacted back in 2008 included an unfavorable provision for sales that occur after that year. The provision can make a portion of your gain from selling an affected residence ineligible for the gain exclusion privilege.

We will call the amount of gain that is made ineligible the non-excludable gain. The non-excludable gain amount is calculated as follows.

Step 1. Take the total gain and subtract any gain from depreciation deductions claimed against the property for periods after May 6, 1997. Include the gain from depreciation (so-called unrecaptured Section 1250 gain) in your taxable income. Carry the remaining gain to Step 3.

Step 2. Calculate the non-excludable gain fraction.

The numerator of the fraction is the amount of time after 2008 during which the property is not used as your principal residence. These times are called periods of non-qualified use.

But periods of non-qualified use don’t include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or other circumstances specified in IRS guidance.

Periods of non-qualified use also don’t include times when the property is not used as your principal residence if those times are 

• after the last day of use as your principal residence, and
• within the five-year period ending on the sale date. (See Example 4 below.)

The denominator of the fraction is your total ownership period for the property.

Step 3. Calculate the non-excludable gain by multiplying the gain from Step 1 by the non-excludable gain fraction from Step 2.

Step 4. Report on Schedule D of Form 1040 the non-excludable gain calculated in Step 3. Also report any unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997, from Step 1. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements.

Some Examples

In our continuing efforts to reduce taxpayer confusion resulting from overly complicated federal income tax rules, we present the following examples that illustrate how to calculate non-excludable gains from principal residence sales.

Takeaways

By reducing your allowable tax-free gain exclusion break, the unfavorable rule examined in this article takes some of the tax-saving fun out of converting a rental property or vacation home into your principal residence.

That said, a reduced gain exclusion is better than no gain exclusion at all.

Finally, converting a property into your principal residence sooner rather than later can give you a better tax result, because it minimizes the period of non-qualified use that can reduce your gain exclusion.

‍