Principal residence sales by international executives after the TRA '97.

By now, everyone knows that the Taxpayer Relief Act of 1997 allowed taxpayers to exclude up to $250,000 of gain ($500,000 if married filing jointly on the sale of a principal residence, if certain requirements are met. what h appens, however, if the seller has been out of the U.S. (i.e., out of the home) on a work assignment? or the seller moves out of the U.S. (i.e., back to his native land) after the sale? These and other thorny questions are analyzed in this article.

Among the changes to the Code in the Taxpayer Relief Act of 1997 (TRA '97) were amendments to the Sec. 121 gain exclusion rules and repeal of the Sec. 1034 gain deferral rules on the sale or exchange of a taxpayer's principal residence. Sec. 121 was amended (and Sec. 1034 was repealed) by TRA '97 Section 312, to provide a single rule permitting gain exclusion only.(1)

The new rule will affect both U.S. expatriates and foreign nationals. As is discussed below, the legislation limits the gain that may be excluded in a qualifying transaction; gain in excess of the limit is subject to tax at the time of the sale or exchange. Further, a taxpayer must own and use the residence as his principal residence for at least two of the five years prior to the sale or exchange to qualify for the full exclusion. A U.S. expatriate taxpayer who rents out his U.S. home during a foreign assignment and reoccupies the home on repatriation for a short period before selling it may not satisfy this requirement.

The TRA '97 also provided that gain attributable to allowable post-May 6, 1997 depreciation of the residence must be recognized on a sale or exchange. As depreciation recapture generally was not recognized under pre-TRA '97 Sec. 1034 or 121, this provision may result in additional tax being attributable when renting out a principal residence during an assignment. Foreign national taxpayers can benefit from the legislation, because U.S. nonresidents are not prohibited from using the new exclusion. In addition, qualifying sales by former U.S. citizens and long-term residents within the five-year lookback period of Sec. 877 should be exempt from taxation under the expatriation rules.

New Law

Generally under TRA '97 Section 312(a), amending Sec. 121, a taxpayer can exclude up to $250,000 of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, under Sec. 121 (a), the taxpayer must have owned the residence and used it as a principal residence for at least two of the five years prior to the sale or exchange ("ownership/use tests"). Under Sec. 121(b)(2), married taxpayers filing jointly may exclude up to $500,000 if either spouse meets the ownership test, both spouses meet the use test and neither spouse is ineligible for the exclusion by reason of a prior sale under Sec. 121(b)(3). Sec. 121,(b)(3) states that the exclusion may be applied to one sale every two years (without regard to any sale before May 7, 1997). Further, according to Sec. 121(d)(6), gain must be recognized to the extent of any depreciation allowable for the rental or business use of the residence after May 6, 1997.

Under Sec. 121(c)(2)(b), a taxpayer who does not meet the ownership/use tests may qualify for a prorated exclusion if such failure is due to a change of place of employment, health or unforeseen circumstances. However, for sales before Aug. 5, 1999, the proration rule applies without regard to the requirement of change of place of employment, health or unforeseen circumstances.

According to TRA '97 Section 312(d), the new law applies to all sales or exchanges of a principal residence occurring after May 6, 1997. However, a taxpayer may instead elect to apply prior law to a sale or exchange (1) occurring before Aug. 5, 1997, (2) occurring after Aug. 5, 1997 under a binding contract in effect on that date or (3) of a replacement residence acquired before Aug. 6, 1997 (or under a binding contract in effect on Aug. 5, 1997) in a qualifying rollover transaction. A pending technical correction would provide that a taxpayer could elect to apply pre-TRA '97 law to a sale or exchange on Aug. 5, 1997.(2) Sec. 121(g) provides that if the taxpayer acquired his current residence in a rollover transaction, periods of ownership and use of the prior residence may be taken into account in determining ownership and use of the current residence.

Dollar Limit

As was discussed, up to $250,000 ($500,000 if married filing jointly) of gain may now be excluded in a qualifying sale or exchange. Any gain in excess of the applicable limit must be recognized at the time of the sale or exchange; thus, a taxpayer may be subject to tax on a portion of the gain from a future sale of his home.

Pre-TRA '97 Sec. 1034 provided for gain deferral on the sale of a taxpayer's principal residence if the taxpayer purchased and used a new principal residence of equal or greater cost than the sales price of the old residence within a specified period. Gain recognition was deferred by reducing the basis of the replacement residence by the gain on the sale of the old residence. Because the adjusted basis of a residence for purposes of the new exclusion is the basis as adjusted by previous Sec. 1034 deferrals, taxpayers may have a low adjusted basis in their current homes. Consequently, taxpayers owning expensive homes or homes that have appreciated substantially may be faced with potential gain in excess of the new maximum exclusion.

Because there is no limit on the amount of gain that can be deferred under pre-TRA '97 Sec. 1034, taxpayers may wish to apply it to the sale of a replacement residence purchased before Aug. 5, 1997 (or under a contract for sale binding on Aug. 5, 1997).

Example 1: T and W, married filing jointly, purchased home A in 1965 for $50,000. In 1992, T and W sold A for $550,000 and purchased home B for $575,000 in a qualifying Sec. 1034 transaction. T and W plan to sell B in 1998 for $775,000 and purchase a new home for $800,000. Their basis in B is $75,000 ($575,000 purchase price -- $500,000 gain deferred on the sale of A). Thus, gain from the sale of B will be $700,000 ($775,000 sales price -- $75,000 basis). If T and W qualify for the post-TRA '97 Sec. 121 exclusion on the sale of B, they could exclude the first $500,000 of gain and the recognize the $200,000 balance in 1998. However, if T and W contracted for the sale of B before Aug. 5, 1997, they could elect to apply Sec. 1034 to the sale of B and purchase of the new home, thereby deferring tax on the $700,000 gain.

The new exclusion will not be indexed for inflation; in the past, Congress has not moved quickly to amend Code sections providing specific dollar amounts not indexed for inflation.

Expatriates

Ownership/Use Tests

As was discussed, Sec. 121(a), as amended, requires the taxpayer to pass ownership/use tests. U.S. expatriates are generally encouraged to retain their homes during an assignment; however, a returning expatriate will often sell his home soon after repatriation. An expatriate who sells his home after an assignment in excess of three years will likely fail the ownership/use tests.

However, a returning expatriate may be able to qualify for a prorated exclusion available to individuals unable to meet the ownership/use tests due to a change of place of employment, health or unforeseen circumstances. (The proration rule applies without regard to these requirements to residences owned on Aug. 5, 1997 and sold before Aug. 5, 1999.) Post-TRA '97 Sec. 121 provides that the amount to be prorated is the lesser of the gain realized or $250,000 ($500,000 if married filing jointly. A pending technical correction(3) would provide that the amount to be prorated is the $250,000 limit ($500,000 if married filing jointly), even if the gain realized on sale is less than the exclusion limit. No exclusion appears to be available to an expatriate who did not occupy his principal residence at any time during the five years prior to a sale or exchange.

Pre-TRA '97 Sec. 1034: As was discussed, prior to the TRA '97, an expatriate who realized gain from the sale of his residence on repatriation may have been able to defer gain recognition under Sec. 1034. However, an issue arose under Sec. 1034 as to whether an expatriate's residence could be considered a "principal residence" if it was sold immediately or soon after his repatriation. Often, the issue was further complicated if the residence was rented out during the assignment (and, arguably, converted to business use).

However, when a taxpayer intended to return to his residence after an assignment but did not reoccupy the home, an argument could successfully be made that the residence before the assignment remained the taxpayer's principal residence during the assignment for Sec. 1034 purposes.(4) Another argument was that a residence converted to trade or business use during the assignment was converted back to a principal residence on return from the assignment. There is no established length of time that a residence must be reoccupied to be considered a principal residence for Sec. 1034 purposes.

PRE-TRA '97 Sec. 121: A residence would not be considered a principal residence for the duration of an expatriate assignment under pre-TRA '97 Sec. 121, which provided a taxpayer 55 or older with an exclusion of up to $125,000 of gain from the sale or exchange of a residence owned and used as his principal residence for at least three of the five years ending on the date of sale or exchange. Regs. Sec. 1.121-1(c) specifies that short temporary absences (e.g., vacations or. other seasonal absences) could be counted as periods of use as a principal residence. However, under Regs. Sec. 1. 121-1(d), Example (4), a one-year sabbatical absence would not be included as part of a period of use as a principal residence. PRE-TRA '97 Sec. 121's strict occupancy requirement contrasts with pre-TRA '97 Sec. 1034; under certain circumstances, the latter allowed a taxpayer's residence to be considered his principal residence although unoccupied by him for a number of years.

Post-TRA '97 Section 121: The IRS will likely strictly construe the occupancy requirement in post-TRA '97 Sec. 121 as it did under pre-TRA '97 Sec. 121. Therefore, the ability of a returning expatriate to use the full exclusion when a residence is not physically occupied by him for at least two out of five years appears to be in jeopardy.

The occupancy requirement means that assignment planning should include consideration of the expatriate's residence. Expatriates may want to sell their homes before or during an assignment if it is unlikely they will qualify for the exclusion on repatriation. In addition, employers may want to provide protection in their equalization policies(5) for expatriates who do not qualify for the exclusion as a result of an assignment.

Example 2: T purchased and lived in a home in New York for 10 years before his employer sent him to Germany for a five-year assignment. During the assignment, T maintained his home in New York. At the end of the assignment, T's employer offered him a job in Washington D.C. T sold his New York home and purchased a home in Washington, D.C. Because T did not actually use his New York home as a principal residence at any time during the last five years, the IRS would likely claim that he is not entitled to exclude the gain from the sale of the home under post-TRA '97 Sec. 121.

Depreciation

Post-TRA '97 Sec. 121(d)(6) provides that gain will be recognized to the extent of any depreciation allowable with respect to the rental or business use of the residence after May 6, 1997. Thus, an expatriate who rents out his principal home during the assignment may be required to recognize gain on its future sale. Recognized gain equals the allowable depreciation during the rental period, even if the total sale gain does not exceed the dollar limit of the exclusion.

Generally, depreciation recapture was not recognized prior to the TRA '97 in a qualifying Sec. 1034 or 121 transaction. Therefore, employers now may want to account in their equalization policies for the additional tax that may result.

However, recognition of gain attributable to depreciation may not result in additional tax on the expatriate's tax return. Losses from the rental of the residence during the assign may have have been suspended due to the Sec. 469 passive activity rules. If the suspended losses at least equal the allowable depreciation, the gain recognition attributable to depreciation may be offset by the allowance of the suspended passive activity loss on disposition of the residence.

Alternatively, if rental of the taxpayer's residence is not considered an activity for the production of income, deductions attributable to the activity would be subject to disallowance under Sec. 183. In the case of rental property, expenses such as depreciation can be claimed only to the extent of the rental income, after deduction of other expenses otherwise allowable under the Code (e.g., mortgage interest and real estate taxes). If rental income does not exceed these otherwise allowable expenses, no depreciation deduction is allowable under the Code. Assuming no depreciation was allowable during the rental period, post-TRA '97 Sec. 121 would not require gain recognition on sale.

If claimed depreciation deductions during the assignment result in deductible losses on the expatriate's U.S. returns, the employer may have received the benefit of these losses through its tax equalization process. Therefore, if recapture on the expatriate's return results in additional income tax, such tax should arguably be the employer's responsibility.

Example 3: T a single individual, rented his home while he was on assignment in Spain. From May 6, 1997 until the end of his assignment, T was allowed $15,000 in depreciation deductions on the rental of his home. T reoccupied his home at the end of his assignment and sold it two years later at a $100,000 gain. Although T qualifies for the $250,000 exclusion, he may exclude only $85,000 of the sale gain and must recognize $15,000 of gain attributable to depreciation of the home after May 6, 1997.

Foreign Nationals

Availability of Exclusion to Nonresidents

The TRA '97 provides for gain exclusion on the sale of a principal residence, rather than gain nonrecognition. Both the House Ways and Means and Senate Finance Committees' Explanations(6) stated that an exclusion was provided in lieu of nonrecognition to ease the basis tracking and recordkeeping burdens associated with nonrecognition transactions spanning many years. However, the structure of the provision as an exclusion rather than as a non-recognition rule may allow nonresident aliens (NRAs) to benefit.

Under Sec. 897(a)(1), gain from the sale or other disposition of a U.S. real property interest by a NRA is generally taxed as income effectively connected with a U.S. trade or business under Sec. 871(b)(1). However, Sec. 897(e) generally limits the use of nonrecognition provisions in the Code in the case of dispositions of U.S. real property interests by NRAs.(7) For example, the use of pre-TRA '97 Sec. 1034 by NRAs was limited by Temp. Pegs. Sec. 1.897-6T(a)(1) to the transfer of a U.S. real property interest for another U.S. real property interest that would be subject to tax on its disposition. However, Temp. Regs. Sec. 1.897-6T(a)(2) also provides that, for Sec. 897 purposes, Sec. 121 is not considered a nonrecognition provision; thus, NRAs did not appear to be restricted under Sec. 897 from using pre-TRA '97 Sec. 121.

Because the new law provided for gain exclusion, not nonrecognition. and amends (not repeals) Sec. 121, use of the exclusion should not be denied to NRAs by Sec. 897. NRAs leaving the US. who wish to qualify for the new exclusion should sell their homes soon enough after departure to satisfy the occupancy requirement. However, departing married foreign citizens may want to sell their US. residences while still U.S. residents, as the $500,000 exclusion is available only if married filing jointly. This is especially important if the US. residence is not jointly owned.

Employers traditionally have discouraged foreign nationals from purchasing homes during a US. assignment. However, the availability of the new exclusion to NRAs, coupled with the lack of a reinvestment requirement (which existed under pre-TRA '97 Sec. 1034(a)), may increase their incentive to purchase homes while on assignment.

Example 4: T, a married foreign citizen on assignment in the US., purchased and lived in a home in New York for five years during his assignment. The home was owned by T alone. At the end of his assignment, T returned to his home country and was no longer a U.S. resident. A year later, T sold the home for a $300,000 gain. As a married NRA in the year of the sale, T is required by Sec. 6013(a) to file married filing separately; thus, T may exclude $250,000 of the gain from income and must pay tax on $50,000 of gain. Under pre-TRA '97 Sec. 1034, T could have deferred the gain on the sale of the New York home only by purchasing another home in the US. for at least as much as the sales price of the New York home.

Expatriators

Post-TRA '97 Sec. 121(e) states that the new exclusion does not apply to "expatriators" (i.e., former U.S. citizens and certain former resident aliens subject to the Sec. 877(a)(1) expatriation rules).(8) Although this provision will prevent use of the exclusion by expatriators who have terminated U.S. residency, it should not affect qualifying transactions that occurred while these individuals were resident during the Sec. 877(d)(2) five-year lookback period.

Sec. 877(d)(2), in conjunction with Notice 97-19,(9) provides that gain will generally be recognized on any otherwise nonrecognition exchange occurring during the 15-year period beginning five years before expatriation that results in a change in the source of gain from the property from U.S.- to foreign-source. This provision requires an expatriator who has exchanged U.S. property for foreign property in a Sec. 1034 transaction in the five years before expatriation to either recognize the deferred gain or enter into a non-recognition agreement with the IRS on expatriation. Because post-TRA '97 Sec. 121 provides an exclusion rather than a deferral, a qualifying post-TRA '97 sale occurring within the five years before an individual's expatriation will not be captured under the Sec. 877 lookback rules, because it is not an exchange of property (as a Sec. 1034 transaction would be). Use of the exclusion during the 10-year period after expatriation is denied to expatriators, because the TRA '97 specifically provides it does not apply.

Example 5: T, a green card holder, purchased and lived in a home in New York for five years during a U.S. assignment. Before the end of his assignment, T sold the home for a $250,000 gain. One year later, T relinquished his green card and was deemed an expatriator under Sec. 877. The tax consequences of the sale of T's home were not affected by his expatriation. Had T sold the residence after be relinquished his green card, he would not have been eligible for the exclusion. Under pre-TRA '97 Sec. 1034, had T exchanged his U.S. home for foreign property before his expatriation, he would have been required either to recognize the deferred gain or enter into a non-recognition agreement with the IRS on expatriation.

Conclusion

The changes made by the TRA '97 to the rules governing the sale of a principal residence have resulted in potential tax traps and new opportunities for US. expatriates and foreign nationals. Assignment planning should be used to avoid unintended results and leverage the benefits provided by the TRA '97.

(1) These rules are discussed in Adkins, Geisler and Thompson. "Selling a Principal Residence After the TRA '97," 29 The Tax Adviser 116 (Feb. 1998).

(2) See Joint Committee on Taxation (JCT), JCT Description of the Chairman's Mark of the Tax Technical Corrections Act of 1997 (JCX-56-97).

(3) Id., Section D.3.

(4) See, e.g., Arthur R. Barry, TC Memo 1971-79; Robert G. Clapham, 63 TC 505 (1975).

(5) Generally, an international employer's tax equalization process is designed so that a U.S. expatriate employee will bear the approximately the same tax burden that he would have borne had he remained in the U.S. (hypothetical U.S. tax). Under a tax equalization plan, the employee agrees to pay his employer his hypothetical U.S. tax (through a reduction in salary or otherwise); the employer agrees to reimburse the expatriate for his actual U.S. and foreign taxes on covered income.

(6) H. Rep't No. 105-148, 105th Cong., 1st Sess. 307 (1997); S. Rep't No. 105-33, 105th Cong., 1st Sess. 350 (1997).

(7) See Temp. Regs. Sec. 1.897-6T.

(8) According too Sec. 877(e)(2), an "expatriator" includes a former U.S. resident alien who held a "green card" (i.e., a permanent residence visa) in at least eight out of the 15 years ending with expatriation.

(9) Notice 97-19, IRB 1997-10, 40.