Refresher: Principal Residence Gain Exclusion Break (Part 3 of 3)
Tax PlanningWith residential real estate markets sizzling, 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 helps!
This is Part 3 of our three-part refresher course on how to navigate the twists and turns necessary to wring the maximum federal income tax savings out of the home sale gain exclusion break, which might be more valuable than ever right now.
For Parts 1 and 2 of our analysis, see Refresher: Principal Residence Gain Exclusion Break (Part 1 of 3) and Refresher: Principal Residence Gain Exclusion Break (Part 2 of 3).
Let’s now get started with Part 3. Here goes.
How to Exclude Gain in Marriage and Divorce Situations
In both marriage and divorce situations, a home sale often occurs. Of course, the principal residence gain exclusion break can come in very handy when an appreciated home is put on the block.
Sale during Marriage
Say a couple gets married. They each own separate residences from their single days. After the marriage, the pair files jointly. In this scenario, it is possible for each spouse to individually pass the ownership and use tests for their respective residences. Each spouse can then take advantage of a separate $250,000 exclusion.
Put another way, each spouse’s eligibility for a separate $250,000 exclusion is determined independently, as if the couple were still unmarried.
Sale before Divorce
Say a soon-to-be-divorced couple sells their principal residence. Assume they still are legally married as of the end of the year of sale because their divorce is not yet final. In this scenario, the divorcing couple can shelter up to $500,000 of home sale profit in two different ways:
- Joint return. The couple could file a joint Form 1040 for the year of sale. Assuming they meet the timing requirements, they can claim the $500,000 joint-filer exclusion.
- Separate returns. Alternatively, the couple could file separate returns for the year of sale, using married-filing-separately status. Assuming the home is owned jointly or as community property, each spouse can then exclude up to $250,000 of his or her share of the gain.
To qualify for two separate $250,000 exclusions, each spouse must have
- owned his or her part of the property for at least two years during the five-year period ending on the sale date, and
- used the home as his or her principal residence for at least two years during that five-year period.
Key point. In many cases, the preceding favorable rules will allow the divorcing couple to convert their home equity into tax-free cash. They can generally divide up that cash any way they choose without any further federal tax consequences, and then go their separate ways.
Sale in Year of Divorce or Later
When a couple is divorced as of the end of the year in which their principal residence is sold, they are considered divorced for that entire year. Therefore, they will be unable to file jointly for the year of sale. The same is true, of course, when the sale occurs after the year of divorce. Here’s the home sale gain exclusion drill in these situations.
Key point. Under the preceding rules, both ex-spouses will typically qualify for separate $250,000 gain exclusions when the home is sold soon after the divorce. But when the property remains unsold for some time, the ex-spouse who no longer resides there will eventually fail the two-out-of-five-years use test and become ineligible for the gain exclusion privilege.
Let’s see how we can avoid that unpleasant outcome.
When the Non-Resident Ex Continues to Own the Home for Years after Divorce
Sometimes ex-spouses will continue to co-own the former marital abode for a lengthy period after the divorce. Of course, only one ex-spouse will continue to live in the home. After three years of being out of the house, the nonresident ex will fail the two-out-of-five-years use test. That means when the home is finally sold, the non-resident ex’s share of the gain will be fully taxable. But with some advance planning, you can prevent this undesirable outcome.
If you will be the non-resident ex, your divorce papers should stipulate that as a condition of the divorce agreement, your ex-spouse is allowed to continue to occupy the home for as long as he or she wants, or until the kids reach a certain age, or for a specified number of years, or for whatever time period you and your soon-to-be ex can agree on. At that point, either the home can be put up for sale, with the proceeds split per the divorce agreement, or one ex can buy out the other’s share for current fair market value.
This arrangement allows you, as the non-resident ex, to receive “credit” for your ex’s continued use of the property as a principal residence. So, when the home is finally sold, you should pass the two-out-of-five-years use test and thereby qualify for the $250,000 gain exclusion privilege.
The same strategy works when you wind up with complete ownership of the home after the divorce, but your ex continues to live there. Stipulating as a condition of the divorce that your ex is allowed to continue to live in the home ensures that you, as the non-resident ex, will qualify for the $250,000 gain exclusion when the home is eventually sold.
Little-Known Non-Excludable Gain Rule Can Mean Unexpectedly Higher Taxes on a Property Converted into Your Principal Residence
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. Those were the good old days!
Unfortunately, legislation enacted back in 2008 included an unfavorable provision for personal residence 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.
Let’s 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.12 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 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 10 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 Step 1 unrecaptured Section 1250 gain from depreciation for periods after May 6, 1997. The remaining gain is eligible for the gain exclusion privilege, assuming you meet the timing requirements.
Key point. The results in Examples 8 and 9 reveal the interesting truth that the non-excludable gain rule can hurt sellers with smaller gains while having no impact on sellers with larger gains.
Tax Planning Implications of Non-Qualified Use
As you see, the unfavorable rule explained above can take some of the tax-saving fun out of converting a vacation home or rental property into your principal residence.
That said, a reduced gain exclusion is better than no exclusion at all.
In addition, the unfavorable rule is less likely to affect highly appreciated properties (compare the results in Examples 8 and 9). 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.
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.
To claim the maximum gain exclusion of $250,000 or $500,000 for married joint-filers, you must pass the ownership and use tests and avoid the anti-recycling rule. See Part 1 of our analysis for details on these restrictions.
If you’re affected by the aforementioned restrictions, you may still qualify for a prorated (reduced) gain exclusion under the rules explained in the earlier Part 2 of our analysis.
If you are getting married or divorced, make sure you pay attention to the December 31 rule: if you are married on December 31, you are married for the year.
In a divorce, if your ex is going to live in the home for a number of years, make sure your divorce lawyer includes the “living there stipulation” in the divorce papers so that you preserve your $250,000 exclusion.
If in 2009 or later, you converted a vacation home or rental property into your personal residence, make sure to understand the non-qualified use rule and its impact, if any, on your taxable gain from the sale of that residence.
