Tax planning for the personal residence in the context of divorce and remarriage: favorable tax provisions concerning property take on special significance in marital rearrangements.

Favorable Tax Provisions Concerning Property Take on Special Significance in Marital Rearrangements

It is often said that buying a home is the best investment most individuals will ever make. In addition to being able to live in the home, the owner has the advantage of a variety of beneficial income tax provisions involving the purchase, ownership and sale of a "principal residence." Those tax deductions, deferrals and exclusions designed to encourage and foster home ownership take on special significance when applied in the context of a pending marriage, divorce or remarriage.

Taxation of Principal Residences

In general, the definition of a principal residence is the same throughout the tax provisions concerning such property. Although a taxpayer may own many personal residences, only one of them may qualify as his principal residence at any particular time.(1) In addition to the typical house, personal residences may include cooperatives, condominiums, trailers, mobile homes, houseboats and even yachts.(2)

When a taxpayer owns and uses several personal residences concurrently, the determination of which one qualifies as the principal residence is based on all relevant facts and circumstances.(3) Under the most prominent criteria, the residence that is occupied the majority of the time will generally be viewed as the taxpayer's principal residence.(4) Also, the courts often evaluate traditional domiciliary indicia in order to determine the taxpayer's principal residence in multiple residence situations. For instance, in Thomas,(5) the taxpayer concurrently owned four personal residences that were occupied at various times during the year. Three of the homes were located in Florida and one in Illinois. The Tax Court determined the Illinois home to be the taxpayer's principal residence since he used it more than any of the others, and because his only business was located there, he filed state income tax returns there, and his wife was registered to vote, contributed to and attended church and had her only driver's license in Illinois.

If a portion of the principal residence is used for purposes other than the owner's abode (i.e., as rental property or in connection with a trade or business), only that portion used as a principal residence is subject to the favorable treatment accorded principal residences.(6)

Among the most notable general tax benefits available to owners of a principal residence, not significantly affected by the prospect of marriage or divorce, are:

"Points": In connection with a mortgage obtained for the purchase or improvement of a taxpayer's principal residence, points are deductible in full as interest in the year paid. In order to qualify, the points paid must not exceed those normally charged pursuant to established business practice in the locale and the indebtedness must be secured by the residence.(7)

Real estate taxes: A purchaser or seller of any real property, including a principal residence, is entitled to deduct the proportionate share of state and local real estate taxes applicable to the portion of the tax year the property is owned by the taxpayer (whether or not such taxes are adjusted or reimbursed at settlement).(8)

Home mortgage interest: With certain limitations, a deduction is allowed for "qualified residence interest" attributable to the aggregate cost (not to exceed $1 million) of acquiring, constructing or substantially improving, plus $100,000 of aggregate equity in, the taxpayer's principal residence and one other qualified residence.(9)

Rollover of Gain on Sale of a

Principal Residence

Sec. 1034(a) permits the deferral of all or a portion of the gain realized on the sale of a principal residence when the taxpayer acquires (by purchase or construction) and uses a new home as his principal residence within the period beginning two years before, and ending two years after, the sale of the old residence.

Example 1: J sells his principal residence on Aug. 14, 1992. A new principal residence acquired and occupied during the four-year period beginning Aug. 15, 1990 and ending Aug. 13, 1994 qualifies J for Sec. 1034 deferral treatment on the sale of the old residence.

Except for members of the U.S. Armed Forces and, under certain circumstances, persons living outside the United States,(10) there are no exceptions or extensions to the two-year replacement period. The Service and the courts have consistently enforced the statutory replacement period strictly, denying a variety of arguments concerning situations beyond taxpayers' control that prevented the timely acquisition, construction or occupation of the new residence.(11)

Under Sec. 1034(b), the taxpayer recognizes gain only to the extent that the adjusted sales price for the old residence (the amount realized on the sale less fixing-up expenses(12)) exceeds the cost of purchasing or constructing(13) the new residence. Obviously, the acquisition of a new residence costing more than the adjusted sales price of the old residence results in complete deferral of gain. However, gain is recognized to the extent the replacement cost is less than the adjusted sales price (not to exceed the amount of the realized gain).

The taxpayer's basis in the new residence is equal to the cost of the new residence less the amount of deferred gain (i.e., the gain realized, but not recognized) on the sale of the old residence. See Example 2 on page 667.

$125,000 Exclusion From Gain on Sale

of Principal Residence

for Taxpayers Age 55 and Over

Sec. 121 permits taxpayers age 55 years or older to elect a once-in-a-lifetime exclusion of gain from the sale of a principal residence, up to a maximum of $125,000.(14) In order to qualify, the taxpayer must meet certain age and holding and use requirements. The taxpayer (or spouse, if the residence is owned jointly and a joint return is filed) must have attained age 55 before the date of the sale, and must have owned and used the home as his principal residence for time periods aggregating at least three years during the five-year period immediately preceding the sale.(15)

An unmarried widow or widower not meeting the holding and use requirement is nevertheless entitled to make the election under Sec. 121(d)(2), if (1) that individual meets the age test and (2) his or her deceased spouse satisfied the holding and use requirement on the date of sale and had never made an election under Sec. 121.

Example 3: J, age 70, has lived in his home for over 20 years. In January 1993, J marries W, age 57, who immediately moves into J's home. J dies in late 1993 and W sells the home in early 1994 at a considerable gain. W may elect the Sec. 121 exclusion. She is deemed to pass the Sec. 121 occupancy test since her husband's previous occupancy was qualified under Sec. 121 as of the date of sale.

If elected, Sec. 121 excludes gain up to a maximum of $125,000 ($62,500 on a separate return by a married taxpayer). However, once used, the exclusion is no longer available even if the gain excluded was less than the maximum allowed. Thus, a taxpayer selling a principal residence for a $40,000 gain (and planning to acquire a replacement residence) should carefully consider whether to make the election or, alternatively, defer the gain under Sec. 1034 and use the Sec. 121 exclusion in conjunction with a later sale of the new residence - possibly excluding a larger amount of gain on the subsequent sale. The age and health of the taxpayer are obvious factors to be considered since the three-out-of-five-year occupancy test must be met with regard to the new home before its sale in order to qualify under Sec. 121.

When the sale of a taxpayer's principal residence produces gain in excess of $125,000, the Sec. 121 exclusion may be used in combination with the deferral of gain under Sec. 1034. The taxpayer simply excludes $125,000 of gain, defers the appropriate amount under Sec. 1034 and recognizes any excess gain on the sale. See Example 4 on page 668.

Tax Aspects of a Principal Residence

in the Face of Divorce

The general tax provisions outlined above take on special significance when applied in the context of a potential divorce or remarriage. For convenience, the discussion below assumes that (1) the community property laws do not apply(16) and (2) the family principal residence is owned by the couple jointly (most likely, tenants by the entirety, the most common manner of owning real estate between husband and wife).

For a typical couple contemplating divorce, there are three basic approaches for handling the family principal residence:

1. One spouse keeps the house: One spouse transfers his interest to the other spouse, who continues to own and reside in the residence after the divorce.

2. Sell the house and divide the proceeds: The residence is sold and the proceeds divided between the spouses, either equally or in some other mutually acceptable manner.

3. Both spouses keep the house: The residence is retained as an investment by the parties after the divorce. The property may be rented to a third party, or to one of the spouses who pays rent to the nonresident spouse attributable to such spouse's interest in the property.

* One spouse keeps the house

The key additional factor under this alternative is Sec. 1041(a), which provides generally that no gain or loss is recognized on a transfer of property to (1) a spouse or (2) a former spouse, if the transfer is incident to the divorce. A transfer is deemed to be incident to the divorce if it (1) occurs within one year after the divorce or (2) is related to the cessation of the marriage. Under the regulations, a transfer is treated as related to the cessation of the marriage so long as it occurs pursuant to a qualified divorce or separation instrument(17) and is accomplished within six years after the marriage ceases. Any transfer not occurring within six years of the divorce is presumed not to be related to the cessation of the marriage. However, this presumption may be overcome by an affirmative showing that the transfer was, in fact, made to effect a division of the property owned at the time of the cessation of the marriage.(18)

In effect, Sec. 1041 treats transfers between spouses or ex-spouses in a manner similar to gifts. That is, no gain or loss is recognized on the transfer and the recipient spouse derives a basis in the property equal to his previous basis, plus an amount equal to the transferor spouse's previous basis.(19)

Example 5: As part of a divorce settlement, H transfers his interest in the jointly owned family residence to W. The total value of the home is $250,000; basis is $150,000. Under Sec. 1041, H has no recognized gain and W takes a new basis of $150,000 (W's previous basis of $75,000 + H's previous basis of $75,000).

Finally, when applicable, the provisions under Sec. 1041 are mandatory even though the transaction is cast as a sale or other taxable transaction and the transferee spouse pays consideration.

Note: The effective date for Sec. 1041 is July 19, 1984. A transfer to an ex-spouse pursuant to a divorce settlement before that date is generally treated as a taxable transaction to the transferor spouse, even though he receives no actual consideration.(20)

Example 6: Assume the same facts as in Example 5, except that the transfer occurs pursuant to a divorce agreement dated before July 19, 1984. H has a recognized gain of $50,000 ($125,000 amount realized - $75,000 adjusted basis). W takes a new basis of $200,000 ($75,000 (her previous basis) + $125,000 (the fair market value (FMV) of H's interest received)).

Note: H may, of course, use rollover treatment under Sec. 1034 or the $125,000 gain exclusion under Sec. 121, if qualified.

When Sec. 1041 applies, the transaction is nontaxable to the transferor spouse, who, therefore, has no need for Sec. 1034 gain deferral or the Sec. 121 exclusion. However, since the recipient spouse inherits the transferor's tax basis, his potential gain has, in effect, doubled in the event the residence is later sold. This factor often substantially increases the required cost of a new home necessary to defer the maximum gain under Sec. 1034. In addition, if the recipient spouse is likely to sell the residence before reaching age 55, or the potential gain is in excess of $125,000, such gain is not excludible under Sec. 121 (or only partially so). This factor is especially significant when the recipient spouse desires not to replace the residence after sale, and is therefore unable to roll over any gain not excludible under Sec. 121. Individuals potentially subject to this problem include those desiring to (1) move into a rental apartment, (2) travel extensively after the sale (thus taking no immediate permanent residence) or (3) marry an individual who already owns a suitable residence.

There is also a possible adverse gift tax consequence under this option unless the transfer is also structured to comply with Sec. 2516. Although transfers between spouses are generally subject to an unlimited marital deduction[2l] (and are therefore gift tax free), such is not the case for transfers between ex-spouses. However, Sec. 2516 generally provides that such transfers will be considered as being in return for "full and adequate consideration in money or money's worth" and, therefore, not subject to gift tax, so long as the transfer is made pursuant to a written agreement relating to marital and property rights, and the divorce occurs within the three-year period beginning one year before the date of such agreement.

Since the requirements for favorable treatment under Sec. 2516 (gift tax) and Sec. 1041 (income tax) are not identical, a potential exists for complying with one, but not the other. For example, a transfer pursuant to an unwritten agreement may comply with Sec. 1041, but not Sec. 2516. Thus, the transfer would not be subject to income tax, but could result in gift tax liability to the transferor spouse. Since gift tax rates can reach as high as 55%,(22) this is a potentially significant problem. The alert practitioner will insure that the transfer of a principal residence between ex-spouses complies with both Sec. 1041 and Sec. 2516.

It is not necessary for the parties' agreement to be incorporated in or approved by the divorce decree for purposes of either Sec. 1041 or Sec. 2516. However, in the unfortunate case of a transfer not meeting the requirements of Sec. 2516 (for example, when the written agreement is not executed within the proper time frame surrounding the divorce), the taxpayer may have another argument to avoid gift tax treatment. The U.S. Supreme Court has held that a transfer required under the terms of a writing that is incorporated in the divorce decree is not a gift since it is, in effect, compelled by the decree.(23)

* Sell the house and divide the proceeds

When the parties agree to sell the family residence before divorce and divide the proceeds equally or on some other agreeable basis, the tax result is fairly straightforward - a sale subject to Sec. 1034 gain rollover and possibly the Sec. 121 gain exclusion.(24)

Assuming the residence was held jointly, the sale transaction results in attributing one-half of the realized gain to each spouse, which may be rolled over by one, neither or both of the spouses, depending on their separate decisions concerning replacement of the residence.(25) Furthermore, the spouses may decide to elect to apply Sec. 121 to exclude gain, or they may decide to preserve the exclusion for separate future use. See Example 7 above.

If, in Example 7, either H or W meets the age and holding and use requirements and they both decide to elect to apply the Sec. 121 exclusion on a joint return, each would, presumably (although there is no direct authority on the point), receive the benefit of one-half of the exclusion.(26) Thus, H would exclude $62,500 and defer the remainder of the realized gain under Sec. 1034, and W would exclude $62,500 gain and recognize the remainder of her realized gain.

In the event the couple elects Sec. 121 during the marriage, neither spouse may elect Sec. 121 again in the future. This same rule applies when one spouse merely joins in the Sec. 121 election in connection with the sale of the other spouse's separately owned residence during the term of the marriage. Both spouses are forever "tainted" by such election, even though the joining spouse had no interest in the property sold, received none of the proceeds and filed a separate income tax return in the year of the sale. To make matters worse, the tainted spouse will also taint and disqualify a subsequent spouse from electing Sec. 121, so long as they are married. (The "tainted spouse" problem will be discussed more fully later.)

* Both spouses keep the house

When the residence is to be retained by the parties subsequent to divorce, the form of ownership is automatically converted from tenants by the entirety to tenants in common.(27) This transformation is a nontaxable event and does not trigger the opportunity (or necessity) to use the Sec. 1034 rollover or the Sec. 121 exclusion.

The parties may structure ensuing affairs such that, subsequent to the divorce, one spouse will continue to reside in the residence and pay a fair rental to the other spouse. Of course, a fair rental would be one-half of the rental for the entire house since the nonresident spouse owns only a one-half interest in the residence. In such case, the house continues to be a principal residence for the resident spouse, but becomes a rental property for the nonresident spouse.

For example, assume that the ex-wife is to reside in the home and pay rent to her ex-husband. Since the home continues to be her principal residence, the wife preserves her ability to roll over gain under Sec. 1034 and to exclude gain under Sec. 121 in the event of a later sale.

The husband, on the other hand, is in a very different position since he is vacating the residence. He will lose the ability to roll over gain on a later sale of the home if it ceases to be his principal residence. Although the rental of a residence prior to sale does not necessarily negate the application of Sec. 1034 or Sec. 121,(28) these provisions will not apply if the required time periods are breached.

If, however, the nonresident husband immediately purchases and occupies a new principal residence, he may be able to roll over gain on a later sale of the family residence if the sale occurs within two years from the date of the acquisition of the replacement residence. (Recall that the Sec. 1034 replacement period includes the two years before, as well as after, the sale of the principal residence.) Furthermore, the husband may qualify for the Sec. 121 exclusion since he will pass the three-years-out-of-five test. However, if the family residence is not sold within the required two-year time frame, neither Sec. 1034 nor Sec. 121 will be available to the husband.

Example 8: On Mar. 1, 1990, H and W obtain a divorce, agreeing to keep the house as tenants in common with W paying H a fair rental attributable to H's one-half interest. H immediately acquires and occupies a new principal residence. Three years later, the couple sells the house at a very large gain. Although W may take advantage of Sec. 1034 rollover treatment (and the Sec. 121 exclusion, if she is 55 years old), H may not, since his new residence was not acquired within the applicable two-year replacement period. Furthermore, H cannot elect Sec. 121, since he fails the three-years-out-of-five occupancy test. Therefore, H must recognize his share of the gain in full.

This situation unfortunately has the potential to occur all too often, especially in view of the liberal policy in many states toward allowing the custodial spouse to live in the family residence in order to preserve a stable environment for the children.(29) Where this judicial discretion is permitted for periods in excess of two years (as is often the case), the nonresident spouse will not qualify for Sec. 1034 rollover or the Sec. 121 exclusion on the later sale of the residence.

Alternatively, the spouses may agree to keep the house as tenants in common and rent it out to third parties. In such case, both ex-spouse co-tenants will be in the position of the nonresident cotenant in the above discussion - perhaps losing the opportunity for Sec. 1034 gain rollover and the Sec. 121 gain exclusion.

Remarriage Issues - Sec. 1034

Although remarriage has an impact on the ultimate tax consequences under all of the approaches discussed in the previous section, the issues are best exemplified by the one spouse keeps the house option, since one spouse's interest in the residence is continuing after the divorce and the other spouse's interest is not.

If one spouse transfers his interest in the family residence to the other spouse before the divorce, the transaction is nontaxable to the transferor spouse under Sec. 1041. Accordingly, such spouse has no need for gain rollover treatment or the Sec. 121 gain exclusion. In such case, a contemplated remarriage does not pose significant personal residence issues for the transferor spouse.

On the other hand, there is substantial concern regarding a possible remarriage of the recipient spouse; most particularly, whether such spouse's situation under Secs. 1034 and 121 meshes with that of a potential new spouse. The recipient spouse's ability to use Sec. 1034 rollover treatment and/or the Sec. 121 gain exclusion will be affected by the new spouse's position regarding his principal residence (perhaps having also come through a divorce). Similarly, the new spouse's tax picture may be affected by the recipient spouse's tax situation.

Assume, for example, that the recipient spouse, looking forward to Sec. 1034 rollover and Sec. 121 exclusion treatment, meets a potential new spouse with similar tax aspirations. If they decide, after marriage, to reside together in one of the residences (either selling, renting or ignoring the other residence), the spouse owning the other residence will lose the opportunity to take advantage of gain rollover under Sec. 1034 for several reasons. First, such spouse is not in a practical position to acquire a replacement principal residence after a sale since the new spouse's home has become their principal residence after the marriage. Furthermore, the old residence will cease to qualify as a principal residence after they move to the new spouse's home.

There are several potential strategies to preserve Sec. 1034 rollover treatment in this situation. First, the couple may decide to attempt to maintain both homes as principal residences of the respective individuals after the marriage. The tax law does not preclude married couples from maintaining separate individual principal residences, making this strategy potentially viable in a limited number of cases, such as professional spouses whose jobs are in different cities. However, this approach is not practical in most situations because of the physical occupancy requirement for qualification of a principal residence.

Another strategy that may be more acceptable in some cases is for both individuals to sell their respective homes (before remarriage when Sec. 121 is an issue, as discussed later), and to jointly purchase a new residence either as tenants by the entirety or tenants in common. This strategy allows Sec. 1034 rollover treatment for both individuals.(30) Of course, the cost of the new home necessary to allow full rollover of the gain attributable to both of the old residences may be fairly large. This factor may render this alternative unacceptable (or only partially helpful) when the gain is very large or when the couple seeks to downsize their residential quarters.

An older newlywed couple may decide to acquire their new residence as tenants in common rather than tenants by the entirety. This situation often arises when (1) the right of survivorship is unsuitable (as, for example, when children from the prior marriage, rather than the new spouse, are the primary beneficiaries of the individual) or (2) the respective old residences have substantially disparate values.(31)

Example 9: A and B are planning to marry (or have already married if Sec. 121 is not an issue). Their old residences are fully paid for and have respective FMV and basis as follows:

                A         B

     FMV     $200,000   $100,000
     Basis    130,000     70,000

In order to defer all gain under Sec. 1034, the couple purchases a new residence for $430,000, taking title as tenants in common as follows: A, 66.666% and B, 33.333%. This strategy allows full gain rollover by both parties and preserves the relative value of the contributions by the parties.

The parties in this example have accomplished the desired objective of allowing both spouses' interest in the residence to be left to their respective heirs (other than the surviving spouse). Furthermore, the ownership interests reflect the appropriate proportions of value contributed by each spouse. However, the approach has a practical downside in that the decedent spouse's heirs will benefit from the ownership of the interest only if the house is sold to a third party or the surviving spouse pays an appropriate rent or buys the interests of the heirs. This scenario has a high potential for causing friction between the parties unless the transaction is appropriately planned well ahead of time.

Another approach that is sometimes suggested, but which is extremely problematic under Sec. 1034, is to have one spouse sell his residence to a third party and then purchase a partial interest in the new spouse's residence as the replacement transaction.

Example 10: H and W (both divorced) are engaged to be married. The FMV and basis of their respective principal residences are:

                H          W

     FMV     $450,000   $180,000
     Basis    200,000    100,000

The couple has agreed that W will sell her residence to a third party before the marriage and use the proceeds to purchase a 40% tenants in common interest in H's residence.

If, in Example 10, W purchases the interest in H's home before the marriage, she will be entitled to Sec. 1034 rollover treatment (and the Sec. 121 exclusion, if qualified) on the sale of the old residence. The sale by H, however, is a taxable transaction not qualified for treatment under Sec. 1034 (or Sec. 121), since a sale of less than the taxpayer's entire interest in the residence does not qualify under these provisions.(32)

Furthermore, should W acquire the partial interest in H's home after their marriage, the application of Sec. 1041 produces a similarly undesirable result. W's purchase of an interest in H's residence is treated as a gift from H.(33) She is, therefore, treated as having incurred no cost to replace the old residence and must therefore recognize her entire gain on the sale of the old residence.

Remarriage Issues - Sec. 121

Application of the Sec. 121 gain exclusion in the remarriage context involves concerns somewhat different from those under Sec. 1034, since Sec. 121 does not require replacement of the residence and may be used only once per lifetime. Thus, an individual (untainted by a previous Sec. 121 election) who satisfies the age and holding and use requirements, and has a potential gain of $125,000 or less, may simply sell his principal residence (excluding all gain under Sec. 121) and move to the new spouse's residence. (Note: This strategy may be particularly desirable when the potential spouse is already tainted, having previously used the Sec. 121 exclusion.) However, if the individual does not qualify for the Sec. 121 exclusion, or the potential gain is substantially in excess of $125,000, the above analysis under Sec. 1034 must be applied to the extent that gain is not excludible under Sec. 12 1.

Most of the remarriage issues in connection with the Sec. 121 election concern individuals who have already benefited, directly or indirectly, from the exclusion. This may have occurred in connection with a prior sale of a solely or jointly owned residence or by joining in the Sec. 121 election with a previous spouse with respect to the sale of such spouse's separately owned residence.(34) In either case, the individual is classified as "tainted" for purposes of future application of Sec. 121.

Example 11: A, soon to be 55, and B, age 40 and divorced, are planning to marry. A's old residence has an FMV of $300,000 and a basis of $100,000. B has never owned a residence, but previously joined in a Sec. 121 election regarding the sale of a residence belonging to her prior spouse. If A sells the home before marrying B, the Sec. 121 election is available, but not if the sale occurs after the marriage, since B is tainted as a result of joining in the previous Sec. 121 election.

A similar situation occurs when neither individual is tainted under Sec. 121, but both desire to apply Sec. 121 to the sale of their respective principal residences. In such case, they must both sell their respective residences before the marriage in order to accomplish both elections. If they marry first, only one will be entitled to the election.35 Furthermore, if one person sells before the marriage, that individual's Sec. 121 election will taint and prohibit an election by the other person concerning a sale after the marriage.(36)

Note that marital status under Sec. 121 is determined at the time of the sale of the residence, not the time of election.37 Therefore, a sale by an individual before marrying a tainted person will not be precluded from See. 121 treatment simply because the election is made (i.e., the tax return is not filed until) after the marriage occurs. The tainted spouse is not required to join in the Sec. 121 election since the individuals were not married at the time of the sale.(38)

The pursuit of the optimum tax treatment often leads to strange circumstances and transactions, as the following example (an actual transaction) illustrates.

Example 12: B and A live on Main Street and are planning to separate and divorce. A's new boyfriend, T, lives in a townhouse around the corner on Maple Avenue. All parties are age 65 or over and have lived in their respective residences in excess of five years. In cooperation with their tax adviser, they have devised the following series of transactions to accommodate the aspects of both love and taxation.

Pursuant to their divorce, B and A will receive a 50% tenants in common interest each in the Main Street residence (total FMV of $300,000, basis of $90,000). After the divorce, B will immediately sell his half interest to T, who plans to move in and marry A later in the year. At about the same time, T will sell his Maple Avenue townhouse (FMV of $150,000, basis of $45,000) to B. Both B and T may use the Sec. 121 exclusion and roll over any excess gain on the sale of their homes. A has preserved her ability to use both the Sec. 121 exclusion and the Sec. 1034 rollover. Of course, T's election to use the Sec. 121 exclusion will taint A if they later marry.

Conclusion

Since the family residence is usually a major (often the primary) asset to be allocated between spouses contemplating divorce, it is critical that the parties seek to take maximum advantage of the tax provisions concerning such property and avoid the traps that may occur as a result of insufficient or improper planning. In addition, the parties and their tax advisers must look beyond the divorce to the effects of a potential remarriage in order to fully evaluate the tax consequences on the disposition of the residence.

(1) Rev. Rul. 66-114,1966-1 CB 181. (2) 2 Regs. Sec. 1.1034-1(c)(3)(i). See also IRS Letter Rulings 8015017 (1/ 18/80) and 8337050 (6/14/83). (3) Regs. Sec. 1.1034-1(c)(3)(i). (4) IRS Publication No. 17, "Your Federal Income Tax" (1993), at 88; Rev. Rul. 77-298, 1977-2 CB 308. (5) Payne E.L. Thomas, 92 TC 206 (1989). (6) Regs. Sec. 1.1034-1(c)(3)(ii). (7) Sec. 461(g)(2). (8) Sec. 164(d)(1). (9) See Sec. 163(h)(3) and (4)(A). (10) The two-year replacement period may be extended up to a maximum of two additional years for taxpayers whose tax home is outside of the United States (Sec. 1034(k)), or who are on extended active duty (in excess of 90 days or for an indefinite duration) with the U.S. Armed Forces after the sale of the old residence (see Sec. 1034(h)(1)). In addition, an eight-year replacement period may be available for those stationed outside the United States or required to reside in on-base government quarters after return from foreign duty (Sec. 1034(h)(2)). (11) See, e.g., Richard W. Henzel, TC Memo 1965-250; Rev. Rul. 69-434, 1969-2 CB 163. (12) Fixing-up expenses are those incurred to assist in the sale of the old residence, such as painting and repairs, which are paid on or before the thirtieth day after the sale for work performed within 90 days before the execution of the contract of sale. (13) Only construction costs incurred and properly chargeable to capital during the applicable replacement period are to be included in the calculation of gain rollover under Sec. 1034. See Sec. 1034(c)(2). (14) Sec. 121(a)(1) and (b)(1). (15) Sec. 121 (a). Note that the ownership and use tests must be met during the same five-year period, but need not be met simultaneously. Rev. Rul. 80-172, 1980-2 CB 56. (16) In community property states each spouse is deemed to own one-half of any property acquired by either the husband or wife during the term of the marriage. Currently, those states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. (17) Sec. 71(b)(2) defines a divorce or separation instrument" as (1) a decree of divorce or separate maintenance, or a written instrument incident to such decree, (2) a written separation agreement or (3) a decree requiring support or maintenance payments from one spouse to another. (18) Temp. Regs. Sec. 1.1041 - 1 T(b), Q&A- 7. (19) Sec. 1041(b). (20) However, Sec. 1041 will apply to a transfer after July 18, 1984 pursuant to an instrument effective on that date, if both spouses (or former spouses) affirmatively elect to have Sec. 1041 apply. Temp. Regs. Sec. 1.1041-1T(f), Q&A-16. (21) Sec. 2523 (a). (22) The Revenue Reconciliation Act of 1993 reinstated the top estate and gift tax rates at 53% (on taxable transfers between $2.5 million and $3 million) and 55% (on taxable transfers above $3 million) for deaths, gifts and transfers after Dec. 31, 1992. (23) Cornelia Harris, 340 US 106 (1950)(39 AFTR 1002, 50-2 USTC [paragraph] 10, 786), rev'g 178 F2d 861 (2d Cir. 1949)(38 AFTR 1235, 50-1 USTC [paragraph] 10, 746). (24) In the event the parties agree to divide the proceeds from the sale of the residence other than equally, a Sec. 1041 transfer will likely have occurred. However, the gain on the sale will be apportioned between the spouses in accordance with their respective ownership interests. (25) In Rev. Rul. 74-250, 1974-1 CB 202, the Service held that spouses were separately entitled to roll over the gain under Sec. 1034, as each was entitled to one-half of the proceeds of the sale under state law. (26) Since the parties could file separate returns and accomplish a division of the Sec. 121 exclusion, it seems reasonable to conclude that the same result should occur on a joint return if the spouses make different decisions concerning replacement of the residence. (27) See Mall v. Johnson, 412 NYS 773 (1979). The primary difference between these two forms of property ownership is that the former includes the right of survivorship. That is, the death of one co-tenant causes the property to be automatically transferred to the surviving co-tenant by law. on the other hand, tenants in common does not carry the right of survivorship and the death of a co-tenant causes the decedent tenant's share of the property to pass to his respective heirs at law or by will. (28) Regs. Sec. 1. 1034-1 (c)(3)(i). See also Stephen Bolaris, 776 F2d 1428 (9th Cir. 1985)(56 AFTR2D 85-6472, 85-2 USTC [paragraph] 9822); Rev. Rul. 59-72, 1959-1 CB 203. (29) For example, Maryland's statute provides that "the court shall exercise its powers ... to enable any child of the family to continue to live in the environment and community that are familiar to the child, and to provide for the continued occupancy of the family home ... by a party with custody of a child who has a need to live in that home." Furthermore, the court may grant possession and use of the home regardless of how the home is titled, owned or leased. Annotated Code of Maryland, Family Law Article, [subsection] 8-206 and 8-208. (30) Rev. Rul. 7S-238, 1975-1 CB 257. (31) Tenants by the entirety and joint tenants ownership require "unity of interest," thus negating unequal ownership percentages. However, tenants in common has no such requirement, making unequal ownership percentages (e.g., 70%/30%) an available option. (32) IRS Letter Ruling 8029088 (4/25/80). (33) Sec. 1041(b)(1). (34) A taxpayer who is married at the time of the sale may elect Sec. 121 only if the spouse joins in the election, regardless of whether the residence is solely or jointly owned. See Sec. 121 (c). (35) Regs. Sec. 1.121-2(b)(1)(ii). (36) Regs. Sec. 1.121-2(b)(2), Example (1). (37) Sec. 121(d)(6). (38) See Regs. Sec. 1.121-2(b)(2), Example (3).