Refresher: Principal Residence Gain Exclusion Break (Part 1 of 3)

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 deal for prospective sellers. If you’re unmarried, the exclusion can shelter up to $250,000 of home sale gain. If you’re married, it can shelter up to $500,000. That can really help!

This is Part 1 of our three-part refresher course on understanding the twists and turns necessary to realize the maximum federal income tax savings out of the home sale gain exclusion break, which might be more valuable than ever right now. Let’s get started.

Gain Exclusion Basics

Unmarried homeowners can potentially exclude gains up to $250,000, and married homeowners can potentially exclude up to $500,000. You as the seller need not complete any special tax form to take advantage.

Report the taxable part of any principal residence gain on Schedule D of Form 1040. 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). These rates assume that lawmakers will enact no retroactive tax rate increase on gains recognized in 2021.

If part of your gain is taxable due to business or rental use of the home, you must also complete 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 real property business or rental gains that are attributable to depreciation

deductions. (Some prefer to think of this as the recapture tax on real property deductions.)

Warning. As explained later, you can claim a full gain exclusion only once during any two-year period.

Pass the Ownership and Use Tests

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

• 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.

Key point. These two tests are completely independent. In other words, periods of ownership and use need not overlap. For purposes of the two tests, two years means periods aggregating to 24 months or 730 days.

What Counts as a Principal Residence?

Good question. IRS regulations say you must evaluate all facts and circumstances to determine whether or not a property is your principal residence for gain exclusion purposes.

If you occupy several residences during the same year, the general rule is that the principal residence for that particular year is the one where you spent the majority of time during that year. Other relevant factors can include, but are not limited to, the following:

Where you work.

Where family members live.

The address shown on your income tax returns, driver’s license, and auto registration and voter registration cards.

Your mailing address for bills and correspondence.

Where you maintain bank accounts.

Where you maintain memberships and religious affiliations.

Special Considerations If You’re Married

If you’re married and you and your spouse file your tax returns separately, you can potentially qualify for two separate $250,000 exclusions, as illustrated by the following example.

If you’re married and file jointly, you qualify for the $500,000 joint-filer exclusion if:

• either you or your spouse pass the ownership test for the property and
• both you and your spouse pass the use test.

When you file jointly, it’s possible for both you and your spouse to individually pass the ownership and use tests for two separate residences. In that case, you and your spouse would qualify for two separate $250,000 exclusions.

Each spouse’s eligibility for the $250,000 exclusion is determined separately, as if you were unmarried. For this purpose, a spouse is considered to individually own a property for any period the property is actually owned by either spouse.

Special Rule for Unmarried Surviving Spouses

As stated earlier, an unmarried individual can potentially exclude up to $250,000 of gain from selling a principal residence while a married joint-filing couple can exclude up to $500,000.

But if you’re a surviving spouse, you’re not allowed to file a joint return for years after the year in which your spouse died—unless you remarry. So, you’re precluded from taking advantage of the larger $500,000 joint-filer exclusion.

Thankfully, there’s an exception to this unfavorable general rule.

Under the exception, an unmarried surviving spouse can claim the larger $500,000 exclusion for a principal residence sale that occurs within two years after the spouse’s death, assuming all the other requirements for the $500,000 exclusion were met immediately before the spouse died.

Key point. The two-year eligibility period for the larger exclusion begins on the date of the deceased spouse’s death. Therefore, a sale that occurs in the second calendar year following the year of death but more than 24 months after the deceased spouse’s date of death won’t qualify for the larger $500,000 exclusion

Beware of 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.15 If one spouse claimed the exclusion within the two-year window, but the other spouse did not, the exclusion is limited to $250,000.

All the earlier explanations assume that you are unaffected by the anti-recycling rule. If you are affected, you are not eligible for the gain exclusion privilege unless:

• You are eligible for a prorated (reduced) gain exclusion under rules that we will cover in Part 2 of our analysis in the September issue, or
• You “elect out” of the gain exclusion privilege for the earlier sale, as explained below.

When to “Elect Out” of the Gain Exclusion Privilege

As a home seller, you always have the option of “electing out” of the gain exclusion deal and reporting your home sale profit as a taxable gain. You make the “election out” by reporting an otherwise excludable gain on Schedule D of Form 1040 for the year of sale. No further action is required to “elect out.”

Note that you can retroactively election out or revoke an earlier election out by filing an amended return at any time within the three-year period beginning with the filing deadline (without regard to any extension) for the year-of-sale return.

An obvious circumstance where the election out can be beneficial is when you have two principal residence sales within a two-year period, with the later sale producing a larger gain. Consider the following example.

Takeaways

In a red-hot market for home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver. It’s one of the most valuable tax breaks for individual taxpayers.

You must pass the ownership and use tests and avoid the anti-recycling rule to claim the maximum gain exclusion of $250,000 or $500,000 for a married joint-filing couple.

If you can’t do all of the above, you may still qualify for a prorated (reduced) gain exclusion in circumstances that we will explain in next month’s Part 2 of our analysis.