Personal Home Exclusion
You are looking into selling your home. While the process can be very stressful, you should be excited as it often symbolizes a new chapter in life. What if I told you that there was a tax code that could make this even more exciting? Under Internal Revenue Code (IRC) Section 121, sellers can exclude up to $250,000 of the gain from the sale of their residential home. This number is $500,000 if the seller is a married couple who files jointly.
As expected, like any other tax break, this personal home exclusion has a strict set of rules that need to be followed precisely in order for your sale to qualify. If you fail to maintain your home ownership within these set parameters, then your sale could be disqualified from the tax exclusion. This would then, consequently, cost you thousands of dollars in taxes. Now listen up, as we consider the many facets of these requirements to ensure that your home sale will qualify.
The first and most important rule is that the exclusion only applies to the sale of your principal residence. You are only eligible to have one principal residence at a time. The IRS determines this with a “fact and circumstances” test. If you happen to own multiple residential properties, I would be sure to take extra steps to ensure that you are indeed selling your “principal residence.” For example, be sure to list the home address on relevant documents such as tax returns, driver’s licenses, voter ID cards, etc. You could also become a member of clubs or groups near this home. While it is not a necessity to do all of this, the more you are able to associate with the home the better.
There is an “Eligibility Test” promulgated by the IRS. The first step is an “automatic disqualification”, this happens if you acquired your home through a 1031 exchange within the past 5 years. There is a second automatic disqualification when you are subject to expatriate tax.
For the second step, “Ownership”, things can get more complicated than it sounds. It is vital that you own the home for at least two out of the past five years immediately before the sale. What exactly does it mean to “own” the home in this step? First, if you as an individual or at least one of the spouses own the home outright, you pass the test. However, if you only own a remainder interest in the home, the sale will only qualify if the buyer is not a related party and you have not already sold an interest in the home. Now, what if the home happens to be owned by a business? A single-owner entity that is not treated separately from its owner for tax purposes, like an LLC for example, can sell a residence and be able to qualify for the exclusion. This sale would still be treated as a sale by the owner since the entity and owner are not treated separately for other tax purposes. If the sale were to be done through an S-Corp or a C-Corp, the sale would not qualify because the exclusion is designed to benefit individuals and not businesses.
Are you ready for it to become even more complicated? When a property is held in a trust, only if the individual is treated as the “owner” of the trust under the IRC will the sale by the trust be eligible for the exclusion. The IRC provides certain rules of ownership under which grantor trusts and revocable trusts generally are treated as owned by the individual grantor, thus making them qualify for the exclusion. If the grantor is not considered to be the “owner”, such as in an irrevocable trust, then the sale by the trust would not qualify.
Going into the third step, “residence” considers how you use the property. As stated before, you must use the home as your residence for at least two of the five years immediately before the sale. In terms of spouses, each individual must meet the residence requirement. Any short absences, such as vacations, will not count against your time. If you happen to use the property for business or rental purposes, your ability to claim the exclusion will not be destroyed so long it is not being used for those purposes at the time of the sale. These circumstances could affect your exclusion calculation, however. Any “business or rental percentage” of your home use for these purposes will be deducted from your exclusion benefits.
An exception to the residency rule is if you were to become physically or mentally unable to care for yourself. The rules can then be altered and so long as you spend 12 months using the residence as your principal residence in the 5 years preceding the sale or exchange, any time that is spent living in a care facility counts toward your 2-year residency requirement. That is dependent upon the facility having a license from a state or other political entity to care for people with your condition.
The exclusion is eligible to apply to many different types of housing facilities. A single-family home, a condominium, a cooperative apartment, a mobile home, and a houseboat each may be the main home and therefore qualify for the exclusion.
The fourth and final step is the lookback period. This step says if you sold another home within the two years prior to this sale and you took a home exclusion on that prior sale, then you will fail the lookback period test.
If you are looking into selling your home and have any questions about the Personal Home Exclusion, reach out to the professionals at The Center for Financial, Legal, and Tax Planning, Inc at our website, www.taxplanning.com or by phone at (618) 997-3436.