Maximizing gain exclusion/deferral when selling a principal residence due to death, divorce or marriage.
Society has experienced dramatic changes over the past several decades. For example, in 1970, only 6.2% of women and 9.4% of men in the U.S. were single at age 30; by 1994, those numbers had risen to 18.8% and 29.4%, respectively.(1) The 1994 divorce rate was more than double the 1960 rate.(2) Between 1960 and 1994, the average person's life expectancy increased by approximately six years, from 67 years to 73 years for men and from 73 years to 79 years for women.(3) Thus, it can be concluded that increasing numbers of home owners are single and many home owners marry more than once during their lifetime.
These societal changes bring important tax implications. Marriage, remarriage, death or divorce can complicate the application of the tax law when a home is sold and/or another is purchased. This article addresses the issues stemming from the purchase, sale or rental of a taxpayer's principal residence because of death, divorce or (re)marriage.
Defining "Principal Residence"
The Code does not precisely define "principal residence"; instead, the qualification of a residence as a principal residence depends on the facts and circumstances.(4) If a taxpayer owns several personal residences, only one may qualify as his principal residence(5); generally, this is the residence the taxpayer occupies a majority of the time.(6) Regs. Sec. 1.1034-1 (c)(3)(i) lists numerous types of property other than houses that have qualified as personal residences, including houseboats, trailers and stock held by a tenant-stockholder in a cooperative housing corporation; condominiums also qualify.(7) A principal residence need not be located in the U.S. to qualify.(8)
In some cases, it may be difficult finding a suitable replacement residence. If the taxpayer sells his principal residence and moves into rental property, the rental property becomes the new principal residence. When a new home is subsequently purchased, the taxpayer must vacate the rental property and actually reside in the new home for it to qualify as his principal residence.(9) If the taxpayer is unable to sell the old principal residence before occupying the new one, the old residence may be rented out temporarily without causing it to lose its status as a principal residence(10); further, the taxpayer may deduct rental expenses incurred without disqualifying the property.(11) However, if the taxpayer rented the residence for an extended period, a court might determine that it was no longer a former principal residence.(12)
Because the determination of a principal residence depends on the facts and circumstances, taxpayers should not automatically assume that their home qualifies as a principal residence for Secs. 1034 and 121 purposes.
Sec. 1034 Gain Rollover
Depending on the cost of the replacement residence, Sec. 1034 requires a taxpayer to defer all or a portion of the gain on the sale of a principal residence. For this purpose, Regs. Sec. 1.1034-1(b)(8) defines "sale" to include a cash transaction or an exchange; Regs. Sec. 1.1034-1(h) adds the replacement of a principal residence due to a condemnation or other involuntary conversion if the taxpayer does not elect to defer the gain under Sec. 1033.
To qualify for gain deferral, Sec. 1034(a) requires the taxpayer to acquire and occupy a new principal residence within the period beginning two years before and ending two years after the date of the sale of the old residence. According to Sec. 1034(h) and (k), this four-year replacement period is extended only for (1) certain members of the U.S. Armed Forces and (2) taxpayers who reside outside of the U.S. A taxpayer can fail the replacement period requirement even if circumstances beyond his control prevent occupancy of the new residence within the requisite period.(13)
Under Sec. 1034(c)(4) and (d), a taxpayer who sells two or more principal residences within a two-year period must calculate the gain deferral on the sale of the first residence by treating the last residence purchased during that period as the replacement residence; thus, gain on the sale of any intermediate residence must be recognized. Gain on the sale of intermediate residences may be deferred if the purchases are necessitated by business reasons and the taxpayer meets the Sec. 217(c) time and distance requirements.
If the taxpayer uses a residence partly as his principal residence and partly for other purposes (e.g., as a home office), only the gain allocable to the portion used as a principal residence may be deferred, according to Regs. Sec. 1.1034-1 (c)(3)(ii). Any gain allocable to the portion of the residence used for nonresidential or business purposes must be recognized under Sec. 1231.
Under Sec. 1034(a), a taxpayer recognizes gain only to the extent the adjusted sales price of the old residence exceeds the cost of the new one. There are three key elements in computing the gain to be recognized: (1) gain realized, (2) adjusted sales price and (3) cost of purchasing the new residence.
According to Regs. Sec. 1.1034-1(b)(5), "gain realized" is the excess of the amount realized over the adjusted basis of the old residence. Regs. Sec. 1.1034-1(b)(4) defines "amount realized" as the selling price (including money received, the fair market value (FMV) of any property received and the amount of liability assumed by the buyer) less selling expenses. For this purpose, "selling expenses" include commissions, advertising expenses, costs of preparing a deed and other legal expenses incurred in connection with the sale.
Under Secs. 1012, 1016 and 1034(e), the adjusted basis of the old residence is the sum of the original purchase price and the cost of any subsequent capital improvements, less any gain previously deferred under Sec. 1034. If a portion of the home has been used for business purposes, the basis must be partitioned between the nonbusiness and business uses; depreciation taken or allowed on the business portion will decrease the business basis. This formula also applies in determining the taxpayer's adjusted basis in the new residence.
Adjusted Sales Price
The adjusted sales price is defined by Regs. Sec. 1.1034-1 (b)(3) as the amount realized, reduced by fixing-up expenses. The amount realized for purposes of the adjusted sales price is the same amount used in determining the gain realized. Fixing-up expenses are defined by Regs. Sec. 1.1034-1(b) as expenses incurred to assist in the sale of the old residence; such expenses must be incurred within the 90-day period ending on the day on which the contract to sell the old residence is entered into and be paid within 30 days of the sale.
Cost of the Replacement Residence
Regs. Sec. 1.1034-1(b)(7) defines "cost of purchasing a new residence" to include all amounts attributable to the acquisition, construction, reconstruction, and capital improvements made during the replacement period. According to Regs. Sec. 1.1034-1 (c)(4), this encompasses not only cash expenditures, but also debt to which the property is subject at the time of the purchase, liabilities that are part of the consideration, commissions and other expenses paid or incurred on the purchase of the new residence. If a taxpayer builds a new residence, only capital costs incurred during the four-year replacement period qualify as the cost of the new residence; consequently, taxpayers should consider making contractual payments for additional projects yet to be completed (e.g., landscaping) before the four-year replacement period expires. Regs. Sec. 1.1034-1 (c)(3)(ii) provides that the cost of the replacement residence does not include any portion used for nonresidential purposes (e.g., a home office).
The new residence need not be purchased with the funds received from the sale of the old residence; thus, the taxpayer may use credit to buy the new home while using the proceeds from the sale of the old home for other purposes. If the new residence is obtained through an exchange, the cost of the new residence is the FMV of the property on the date of the exchange.
Sec. 121 Gain Exclusion
Taxpayers can elect under Sec. 121 to exclude up to $125,000 ($62,500 if married filing separately) on the sale, exchange or involuntary conversion of a principal residence; the excluded gain constitutes a permanent deferral from income tax. Sec. 121(b)(2) permits the election only once during the taxpayer's life. The taxpayer must meet the following:
1. Be at least 55 years old before the date the residence is sold (Sec. 121(a)(1)).
2. During the five years prior to the sale, owned and used the property as his principal residence for a period aggregating at least three years (Sec. 121(a)(2)). The ownership/use test may be satisfied, according to Regs. Sec. 1.121-1(c), by establishing ownership and use for 36 months (or 1,095 days); short temporary absences (e.g., vacations) are counted as periods of use, even if the residence is rented during the absence.
If a married couple filing jointly owns the residence as joint tenants, tenants by the entirety or community property, Sec. 121(d)(1) allows the exclusion as long as one of the spouses meets both the requirements; thus, the exclusion is not available if one spouse meets the age requirement and the other spouse meets the ownership/use requirement. In addition, each spouse must consent to the election.
If a married couple files separately, each spouse must meet the age and ownership/use requirements and consent to the election. Each may exclude up to $62,500 on the return.
Once a taxpayer has made a Sec. 121 election, Sec. 121(b)(2) bars him and his spouse (or any future spouse) from making the election again. If either spouse has previously made the election, neither can ever make it again.
Combining Exclusion and Rollover
If a Sec. 121 election is made, any gain realized in excess of the $125,000 exclusion must be recognized unless Sec. 1034 applies. Sec. 121(d)(7) directs that, in computing the gain to be deferred under Sec. 1034, the amount excluded under Sec. 121 is deducted in calculating the amount realized.
A Sec. 121 election can be revoked only if the time for claiming a refund has not expired,(14) even if the taxpayer later realizes that some or all of the excluded gain could have been deferred under Sec. 1034.(15) A Sec. 121 election is "used" no matter the amount of gain excluded (i.e., $1 to $125,000).
Death of a Spouse
The death of a spouse can significantly affect the tax results of the sale of the couple's principal residence by the surviving spouse; Sec. 121 applies differently and a new basis is created in the residence.
Applying Sec. 121
An important exception to the Sec. 121 requirements exists for a surviving spouse age 55 or older who does not meet the ownership/use test. Under Sec. 121(d)(2), if the surviving, spouse sells the property prior to any remarriage and the deceased spouse satisfied the age and ownership/use tests, the surviving spouse can make a Sec. 121 election (assuming no previous election had been made).
Effect on Basis
A spouse's death affects the surviving spouse's basis in the principal residence, depending on whether the couple owned the home as community property, joint tenants (tenants by the entirety) or tenants in common. Joint tenancy (and tenancy by the entirety) typically involves rights of survivorship, while tenancy in common does not.
Community property: Taxpayers living in community property states(16) usually own property with their spouses as community property. The exact determination of which property is community property varies by state, but generally includes any property acquired by either spouse during marriage (other than property received by gift or inheritance). Community property is deemed owned one-half by each spouse, regardless of who actually purchased or has title to it.(17)
Because community property belongs to each spouse equally, the estate of a deceased spouse includes only one-half of the property. Normally under Sec. 2013(a), property included in an estate takes a basis of FMV on either the date of the decedent's death or the Sec. 2032 alternate valuation date. In addition, Sec. 1014(b)(6) provides that the surviving spouse's half of the community property (i.e., the half not included in the decedent's estate) is treated as having been acquired from the decedent; thus, the entire basis in a residence owned as community property is increased to its FMV on the first spouse's death.
Joint tenants and tenants in common: Taxpayers living in common-law states may own property with a spouse either as joint tenants (tenants by the entirety) or as tenants in common. Typically, a taxpayer in a common-law state holds property with a spouse as a joint tenant. Regardless of which spouse provided the funds to acquire the property, Sec. 2040(b) requires one-half of the value of such property to be included in the gross estate of the first to die. Thus, when the first spouse dies, the surviving spouse takes an FMV basis in one-half of the property and retains the existing basis in the other half.
Taxpayers who hold property as tenants in common own it according to their initial contributions to its acquisition; thus, if the decedent spouse contributed one-third of the purchase price of a residence, only one-third of its value is included in his estate and receives an FMV basis.
Example 1: D and K lived in their home for 25 years prior to D's death. The house cost $100,000; D contributed $20,000 and K $80,000. D left his portion of the home to K The residence's FMV at his death was $300,000.
* Community property: If D and K resided in a community property state, K's new basis in the residence would be $300,000.
* Joint tenants: If D and K lived in a common-law state and owned the property as joint tenants or tenants by the entirety, only half of the residence would receive a new basis; thus, K's new basis would be $200,000 (($300,000 x 0.5) + ($100,000 x 0.5)).
* Tenants in common: If D and K lived in a common-law state and owned the property as tenants in common, only D's portion of the residence would receive a new basis. Because D owned 20% of the home, K's new basis would be $140,000 (($300,000 x 0.2) + ($100,000 x 0.8)).
Complications of Divorce
Under Sec. 1041, no gain or loss is recognized for income tax purposes on transfers of property incident to divorce. Sec. 1041(c) defines a transfer incident to divorce as one that (1) occurs within one year after the date the marriage ceases or (2) is related to the cessation of the marriage. Temp. Regs. Sec. 1.1041-1T(b), Q&A-6 and -7, provides that a transfer is related to the cessation of a marriage if made within six years of the divorce and pursuant to a divorce or separation decree (as defined in Sec. 71(b)(2)). Transfers incident to a divorce are gifts for income tax purposes. Thus, the spouse transferring the property recognizes no gain or loss; under Sec. 1041(b) and Temp. Regs. Sec. 1.1041-1T(d), the spouse receiving the property takes the transferor's carryover basis, even if the transfer is a bona fide sale.
Example 2: A and P divorced on Jan. 15, 1997. On May 1,1997, P transfers his interest in the marital home to A in exchange for cash equal to the FMV of his interest. Because the transfer occurs within one year of the divorce, there are no income tax consequences; P recognizes no gain or loss on the transaction; A takes P's carryover basis in the portion of the property transferred.
Example 3: The facts are the same as in Example 2, except the transfer occurs on May 1, 1998. If the transfer is made pursuant to the divorce decree, P recognizes no gain or loss; A takes P's carryover basis in the property transferred. However, if the transaction is not pursuant to the decree, it is a sale; thus, P will recognize any realized gain or loss and A's basis in the portion of the property transferred is the FMV (or the amount paid).
Transfers between spouses are generally free from gift tax due to the Sec. 2523(a) unlimited marital deduction, but transfers between ex-spouses do not so qualify. Sec 2516 provides that if divorce occurs no more than one year before and two years after the parties enter into a written agreement, property transferred under such agreement is transferred for full and adequate consideration if the transfer is made as a settlement of marital or property rights or to provide for the support of a minor child. Thus, transfers between ex-spouses can escape gift tax if structured correctly.
Example 4: K and R divorced on Dec. 15, 1996. Pursuant to a written agreement dated Dec. 1, 1996, R transfers his interest in the marital home to K on May 1, 1997. Because the divorce occurred no more than one year before and two years after the written agreement, the transfer is not subject to gift tax. If there were no written agreement, the transfer would be subject to gift tax.
The Couple Sells the Residence
If the marital residence is sold either before or after the divorce and the sales proceeds are divided, each spouse may use Sec. 1034 to defer the gain on sale by purchasing a new qualified principal residence. For Sec. 121 purposes, if the couple sells the home and elects to exclude a portion of the gain while still married, only one election is allowed; the $125,000 exclusion limit will be split between them. However, if they wait until legally separated or divorced to sell, each can take the full exclusion. For this purpose, Sec. 121(d)(6) states that marital status is determined at the time of the election; an individual legally separated from his spouse is not considered married.
Example 5: J, age 60, and A, age 58, have decided to divorce and sell their jointly owned home; the gain on sale is $300,000, which they agree to divide as part of the divorce settlement. If they sell the home and make a Sec. 121 election before the divorce, each could exclude $62,500 ($125,000 x 0.5) of gain under Sec. 121(b)(1), leaving each with $87,500 (($300,000 x 0.5) - $62,500) of gain to recognize or defer under Sec. 1034. However, if J and A wait until after the divorce to sell the home, each would be entitled to exclude $125,000 of gain, leaving only $25,000 (($300,000 x 0.5) - $125,000) of gain for each to recognize or defer. Selling the home after the divorce allows them two separate exclusions of $125,000, thereby doubling the total gain excluded.
Transferring the Residence to One Spouse
Often in connection with a divorce, one spouse transfers his interest in the home to the other. The transferee (resident ex-spouse (RX)) is still entitled to the benefits of Secs. 1034 and 121 if he meets the requirements; however, because the transfer is a gift for income tax purposes, when the RX subsequently sells the residence, the entire gain on sale becomes taxable, including the portion previously belonging to the nonresident ex-spouse (NRX).
A problem may arise if the RX owns and lives in the home but the NRX (who does not occupy or own an interest in the home) continues to pay the mortgage. The NRX paying the mortgage cannot deduct the interest, because the home is not the NRX's qualified residence under Sec. 163(h)(4)(A); further, the RX cannot deduct the interest paid by the NRX.
However, if the Sec. 215 alimony rules are met, the payor NRX may deduct the entire mortgage payment (i.e., interest and principal) as alimony (an above-the-line deduction) Sec 71 (b) dictates that the payments be made pursuant to a written separation or divorce instrument under which the payor is not liable to continue the payments after the payee's death.(18) Thus, to maximize the benefit for both spouses, the payments should be structured as deductible alimony. The payee must recognize the payments as income, but may be able to deduct the interest paid as mortgage interest, even if the payor makes the mortgage payments directly to the mortgage company.(19)
Example 6: When L and M divorced, L was given full ownership of the marital home. The divorce decree required M to pay L an amount equal to the mortgage payments on the home until L remarried or died. M can deduct these payments as alimony; while L must recognize these payments as income, she may deduct the portion attributable to interest if she itemizes.
Example 7: The facts are the same as in Example 6, except that M is required to make the payments only until his son, who lives in the home with L, turns 18. The payments are nondeductible child support. While L is not required to recognize the payments as income, if she makes the mortgage payments, she may be able to deduct the mortgage interest.
Both Spouses Retain Their Interests
A couple's principal residence is often the largest marital asset to be divided on divorce. When the home must be divided between spouses, courts often determine that one ex-spouse should continue to live in the home with the children (i.e., become the RX), while both ex-spouses retain their interests in the home. If the home is not sold within two years of the time the NRX vacates it, it will no longer qualify as his principal residence under Sec. 1034; thus, he will not be able to defer his share of gain on sale. Additionally, the NRX will no longer meet the Sec. 121 requirement, because he did not reside in the home for three out of the past five years. However, if the NRX immediately purchases a new home and the marital home is sold within two years, the time requirements of both Secs. 1034 and 121 are met.(20) Because the home is also considered the RX's principal residence, the RX may also be eligible.
Example 8: J and R divorced on Nov. 1, 1994; each retained an interest in the marital residence. J purchased a new home immediately, while R continued to live in the marital home with their 16-year-old son, G. After G left home to attend college in August 1996, R sold the home and purchased a new one. Because the marital home was sold within two years of the dated vacated it and J purchased a new principal residence, he meets the Sec. 1034 replacement period requirements; R also qualifies for Sec. 1034 treatment. As long as each is 55 or older, each also qualifies for the Sec. 121 exclusion.
Renting the Residence to the RX
Often, when each ex-spouse retains an interest in the former marital residence and one of them continues to reside there, the RX pays rent to the NRX; the latter may be allowed to deduct expenses associated with the rental property. However, if the NRX then uses the property for personal purposes during the tax year, the rental expenses must be allocated between rental days and personal use days, under Sec. 280A(e)(1).
However, if under Sec. 280A, the property is considered the NRX's residence, the deductibility of rental expenses is limited to the rental income from the property. The property is the NRX's residence under Sec. 280A(d)(1) if he has personally used it for more than the greater of (1) 14 days or (2) 10% of the number of rental days during the year. Prior to the divorce, the NRX may have lived in the home; thus, in the absence of an exception, in the year of divorce the NRX might automatically meet the Sec. 280A(d)(1) residence test, limiting the deductibility of rental expenses.
To prevent this result, Sec. 280A(d)(4)(A) excludes from personal use any period during which the NRX used the home as his principal residence before or after renting it to the RX.
After vacating the home, the NRX is not deemed to use it for personal purposes under Sec. 280A(d)(3) and Prop. Regs. Sec. 1.280A-1(g) if he charges the fair rental of the entire unit commensurate with his proportionate interest in it. Prop. Regs. Sec. 1.280A-1(e)(3)(iii) provides that the determination of a fair rental depends on the facts and circumstances at the time of the rental agreement.
If the taxpayer does not use the home for personal purposes more than the greater of 14 days or 10% of the fair rental days, the Sec. 183 hobby loss rules may limit the deductibility of expenses related to the rental property, unless the taxpayer can demonstrate a profit motive.(21) In Bolaris,(22) profit motive was demonstrated by renting the residence at a fair rental; thus, the NRX can demonstrate a profit motive by renting the residence to the RX at a fair rental.
In some cases, the RX may not pay a fair rental (e.g., because the couple's child is also residing in the home). In such case, the NRX is deemed under Sec. 280A(d)(2)(C) to have used the property for personal purposes for the rental period and cannot deduct rental expenses. However, because the NRX is treated as using the home for personal purposes, it may qualify as his second residence under Sec. 163(h)(4)(A)(i)(II), allowing him to deduct the mortgage interest when less than fair rent is charged.
Alternatively, for purposes of Sec. 163(h)(4)(A)(i)(II), the home may also qualify as the NRX's second home under Sec. 163(h)(4)(A)(iii) if the NRX charges no rent. Consequently, the NRX may be able to deduct his portion of the mortgage interest paid.(23)
While the NRX may deduct the portion of mortgage interest attributable to his interest in the home either as an expense in connection with rental property or as an itemized deduction, any mortgage interest he pays on the RX's interest in the home cannot be deducted as such; instead, these payments must meet the alimony requirements discussed earlier to be deductible.
Even when neither ex-spouse continues to occupy the residence, they may decide to retain their ownership interests and convert the home to rental property. As discussed under the definition of a principal residence, if the home is not occupied for a long time, the IRS might argue that the principal residence has been abandoned(24); consequently, the benefits of Secs. 1034 and 121 will no longer be available. The same rental rules discussed previously apply in determining the portion of deductible rental expenses. In the year of divorce, the expenses are allocated between the days the couple resided in the home and the days the home was rented. After the year of divorce, the ex-spouses are not likely to use the home for personal purposes and should be able to deduct all of the rental expenses, unless limited under the Sec. 469 passive loss rules.
The Effects of Marriage
As mentioned previously, many individuals are marrying at an older age, either for the first time or after divorce or the death of a spouse. In many of these cases, one or both of the individuals may already own a principal residence. When a couple decides to marry, they may need to consider the effect the marriage will have on the sale of such residence. The consequences of the related sale and marriage depend on the age of each taxpayer and whether one or both own homes.
Sec. 1034 Considerations
Generally, if a taxpayer sells his principal residence and purchases a replacement home not titled in his name, Sec. 1034 deferral is denied.(25)
Example 9: M, a widow who has previously used her Sec. 121 election, sells her home (to which she has title) and realizes a $35,000 gain on the sale. M decides to reinvest the proceeds in a new home, with sole title in the name of her only son, D. Because the tide to the new home is not in M's name, she cannot defer the $35,000 gain under Sec.1034 and may be subject to gift tax on the transfer of tide to D.
Sec. 1034(g) and Regs. Sec. 1.1034-1(f)(1) provide an exception to this rule; when a married couple uses both the old and the new home as their principal residence, all gain from the sale of the old residence may be deferred as allowed by Sec. 1034, no matter how the homes are owned, as long as both consent to such treatment. However, for Sec. 1034(g) consent to apply, the spouses must remain married to each other; the same husband and wife must use the new residence as their principal place of residence.
In Snowa,(26) the taxpayer and her ex-husband sold their jointly owned home and split the proceeds: thus. she could defer half of the gain on the home. When the taxpayer remarried, she and her new husband purchased a new home together, holding the residence as joint tenants. Because they owned the replacement home as joint tenants, and because she was ineligible to make the Sec. 1034(g) consent (because she had changed husbands), only one-half of the purchase price of the new residence counted for purposes of deferring her gain on the former residence.
When one or both taxpayers sell homes to combine households, several issues may arise; one is whether one or both taxpayers may use Sec. 1034. Another question is how to allocate the basis of the new home between the two owners.
One taxpayer sells a residence: If only one of the taxpayers sells his home to purchase a new marital residence, careful advance planning is needed in acquiring the new residence to maximize the Sec. 1034 rollover. If the individual selling the former residence purchases a new marital residence and titles the property in his name alone, the entire purchase price of the new home is used in computing the gain deferred under Sec. 1034. The taxpayer then could transfer an interest in the residence to his spouse.
If a new residence is acquired with resources from both spouses but title in the new property is held only by the spouse who previously sold a home, under Snowa, the taxpayer must be able to prove that any payment from the nonselling spouse was a gift or loan and that there is no legal obligation to transfer an interest in the property to that spouse. If the owner-spouse transfers the interest to his new spouse after the marriage without being legally required to do so, the transaction falls under Sec. 1041 and, for income tax purposes, is a gift rather than a sale.
The timing of the purchase of the residence, however, is more complicated; the tax consequences depend on whether the taxpayer lives in a common-law or community property state. In common-law states, the taxpayer may acquire the residence after the marriage and own it in his name exclusively. Thus, a taxpayer residing in a common-law state can purchase a replacement home either before or after the marriage and defer gain from the old residence against the entire cost of the new residence, as long as the title to the home is exclusively in that taxpayer's name.
In community property states, however, property purchased after the marriage with community property funds (i.e., funds earned while married) is deemed owned equally by each spouse. A taxpayer wishing to use the entire cost of the new home to defer gain under Sec. 1034 should purchase the replacement home with his own funds before the marriage. However, any portion of the home purchased with a mortgage will probably be community property, because the mortgage will likely be paid with funds earned after the marriage. Depending on the law of the particular community property state, a married taxpayer may have separate funds that he earned before the marriage; property purchased after marriage with such funds is separate property. Thus, the taxpayer may defer the gain against the entire cost of the new residence, as long as the mortgage is paid with those funds.
Both taxpayers sell residences: When both spouses sell homes and purchase a new marital residence, each taxpayer may postpone the gain from the sale of the old property against his share of the cost of the new residence.(27) Each spouse's share of the cost of the new residence is the portion equal to his interest in the home under applicable state law.(28)
Thus, in community property states, each spouse may defer gain against one-half of the cost of the new marital home purchased with community property funds. If each spouse contributes separate funds directly to the purchase of the new home (the title to the residence would be in both spouses' names in proportion to the amount each transferred), each may defer gain against the portion of the purchase price each contributed.
In common-law states, the spouses may purchase the property as joint tenants; each spouse may then defer the gain against one-half the cost of the residence. Alternatively, they can purchase the property as tenants in common, which allows them to divide the ownership in any proportion they desire. Tenancy in common allows the spouses to structure ownership of the new home so as to maximize gain deferral from the sale of the two old residences.
Example 10: M and P sell their separate residences in anticipation of their marriage. M's basis was $100,000; she sold her home for $200,000. P's basis was $50,000; he sold his home for $250,000. M and P purchase a new home as joint tenants for $450,000; each may defer gain against half the purchase price ($225,000). Thus, M is treated as having invested $225,000 in the new residence. Because the proceeds from the sale of her old residence were $200,000, she may defer her entire gain. On the other hand, P received X250,000 from the sale of his residence. Because he is treated as investing only $225,000 in the new residence, he must recognize a $25,000 gain. Had M and P purchased the residence as tenants in common, with M owning 44.45% ($200,000/$450,000) and P owning 55.55% ($250,000/$450,000), both M and P could have deferred their entire gains.
Both taxpayers own residences; one taxpayer sells a residence: Either of two situations may arise when both spouses own residences and one spouse sells his to move into the other spouse's home. Each situation may require one spouse to recognize some gain.
One option for the selling spouse is simply to recognize the entire gain on sale. The gain is recognized because the taxpayer has not purchased a replacement residence, so that Sec. 1034 does not apply.
Another option is for the selling spouse to purchase an interest in the other spouse's home; however, for this to be deemed an actual purchase (rather than a gift), the transaction must occur before the marriage(29); otherwise, for income tax purposes, the sale between spouses is a gift under Sec. 1041(b)(1). Also, the spouse selling an interest in a home to the prospective spouse must recognize any gain on the portion of the residence sold, because the sale does not meet Sec. 1034's requirements.(30) Taxpayers should carefully consider these two options to determine which will minimize total gain recognition.
Example 11: K and M are engaged. K plans to sell his home before the marriage and move into M's home. K's home has a basis of $70,000; he sells it for $100,000. M's basis in her home is $150,000; its FMV is $300,000. If K wants to defer the $30,000 gain ($100,000 - $70,000) on the sale of his home, before the marriage he must purchase a one-third interest in M's residence for $100,000. However, the sale forces into recognize a $50,000 gain ($100,000 - $50,000 (one-third of her basis)). The preferred choice is for K to recognize the $30,000 gain on the sale of his home, rather than purchase an interest in M's residence.
Example 12: The facts are the same as in Example 11, except that K's basis in his home is $20,000, while its FMV is $50,000. If K wants to defer his $30,000 gain, before the marriage he must purchase a one-sixth interest in M's home for $50,000. M must recognize a $25,000 gain ($50,000 - $25,000 (one-sixth of her basis)). The preferred choice is for K to defer his $30,000 gain and purchase the interest in M's home.
The FMV of the homes and the potential gain on each home affect which of the two alternatives will result in the lower gain recognized. However, the Sec. 121 election may also apply and may significantly affect the outcome in each case.
Sec. 121 Considerations
Because a married taxpayer must obtain spousal consent to make a Sec. 121 election, previous elections by either spouse must be considered when deciding when to sell a residence.
Both taxpayers age 55 or over: If one or both spouses own qualified residences, but only one spouse plans to sell, the timing for selling the home and making the election depends on whether the new spouse has previously made an election.
As was noted, Sec. 121(b)(2) and Regs. Sec. 1.1212(b)(1)(ii) prevent a spouse from making the election if the other spouse has previously made the election. Thus, the taxpayer should sell the home and make the election before the marriage.(31) Under Sec. 121(d)(6), the determination of marital status is made at the date of sale, not at the date of the election; even when a residence is sold in the same tax year as the marriage, if the sale occurs before the marriage, the taxpayer need not obtain the new spouse's consent (or worry about a previous election by the new spouse) to make the Sec. 121 election.
If the new spouse has not previously made or consented to a Sec. 121 election, the election may be made even if the residence is sold after the marriage. However, the new spouse may prefer that the home be sold before the marriage so that consent is not required; in the event of subsequent divorce or death of the selling spouse, the new spouse will be able to make a future Sec. 121 election, provided the other requirements are met.
One taxpayer age 55 or older: If a spouse who plans to sell a qualified residence is age 55 or older and meets the ownership/use test, the residence may be sold either before or after the marriage. If the transaction occurs after the marriage, the new spouse must consent to the election and will be unable to make a subsequent election.
When the spouse selling the qualified residence is under age 55, but the new spouse is at least age 55, no Sec. 121 election can be made until either the selling spouse reaches age 55 or the new spouse has dived in the home for three years.
Example 13: C, age 49, has owned and occupied her home for the previous 15 years; her new husband, R, age 56, does not own a home. C sells her home and purchases a new one with R. C satisfies the Sec. 121 ownership/use test, but does not meet the age requirement; thus, she cannot make a Sec. 121 election. R meets the Sec. 121 age requirement, but not the ownership/use test, and so cannot make a Sec. 121 election. Although together they meet the requirements, neither C nor R individually meets the requirements. Thus, C should purchase the new home in her name alone to maximize her Sec.1034 gain deferral. As previously explained, she may subsequently transfer an interest to R as a gift.
If both spouses sell residences and meet the ownership/use test for their respective homes, but only one spouse meets the age requirement, an election may be made to exclude the gain on the sale of the residence owned by the spouse meeting the age test, whether the house is sold before or after the marriage. According to Regs. Sec. 1.121-5(a)(1)(iii), no election can be made to exclude the gain from the sale of the younger spouse's residence, because that spouse does not meet the age test.
Example 14: The facts are the same as in Example 13, except that R has owned and occupied a home for nine years; he sells it after marrying C. C then sells her residence. Because R individually meets the age and ownership/use tests for his home, he may elect to exclude up to $125,000 of the gain under Sec. 121. No Sec. 121 election may be made for C's home, because she does not meet the age requirement; however, both R and C qualify for Sec. 1034 gain deferral.
Example 15: The facts are the same as in Example 13. While R qualifies for the Sec. 121 election, he may wish to defer the gain under Sec. 1034. If his gain is less than $125,000 and the potential gain on the sale of the new marital home (the basis of which is the purchase price, reduced by any deferred gain from the sale of both R's and C's homes) is more than his gain, he should use Sec. 1034 to maximize gain deferral. Thus, R and C will then be able to use the Sec. 121 exclusion when they sell their new home, potentially excluding more gain than if R made the election on the sale of his previous home. R later sells his premarital residence for $90,000 and elects under Sec. 121 to exclude the $50,000 gain realized; R and C later purchase a home for $190,000. Ten years later, they sell the residence for $355,00(:). Because R made a Sec. 121 election on the first sale, he and C cannot exclude any of the $165,000 ($355,000 - $190,000) gain on the sale of their marital home. Thus, R wasted $75,000 ($125,000 - $50,000) of the $125,000 exclusion by electing to exclude the gain on the sale of his premarital home rather than waiting to exclude the gain on the sale of his marital home.
A change in social mores has significantly increased the occurrence of situations in which Secs. 1034 and 121 may provide tax relief. However, the sale, purchase or rental of a personal residence in conjunction with the death of a spouse, divorce or marriage requires caution and careful planning. If structured properly, taxpayers in these situations may significantly benefit from the Code's deferral and nonrecognition provisions.
(1) Rubin, "People Don't Know Right From Wrong Anymore," 9 Tikkun 13 (1994).
(2) Johnson and Dailey, 1996 Information Please Almanac (Houghton Mifflin Company, 49th ed., 1995), p. 835. The divorce rate in 1960 was 2.2 per 1,000 population; in 1994, it was 4.6.
(3) Mink, "Marketing to Women," 34 Credit Union Executive 38 (Mar. 1994);Johnson and Dailey. id., p. 134.
(4) Rev Rul. 59-72, 1959-1 CB 203, revoking Rev. Rul. 55-222, 1955-1 CB 349.
(5) Rev, Rul. 66-114, 1966-1 CB 181.
(6) Rev. Rul. 77-298, 1977-2 CB 308.
(7) Rev, Rul. 64-31, 1964-1 CB 300.
(8) Rev Rul. 54-611, 1954-2 CB 159.
(9) William C. Stolk, 326 F2d 760 (2d Cir. 1964)(13 AFTR2d 535, 64-1 USTC [paragraph] 9228). aff'g 40 TC 345 (1963).
(10) Rev, Rul. 78-146, 1978-1 CB 260.
(11) Stephen Bolaris, 776 F2d 1428 (9th Cir. 1985)(56 AFTR2d 85-6472, 85-2 USTC [paragraph] 9822), aff'g, rev'g and rem'g 81 TC 840 (1983).
(12) Richard T. Houlette, 48 TC 350 (1967); Rev. Rul. 55-222, note 4.
(13) Joseph T. Gelinas, TC Memo 1976-103.
(14) Under Sec. 6511(a), a refund can be claimed by the later of (1) three years from the date the return was filed or (2) two years from the date the tax was paid.
(15) See Mary K. Robarts, 56 F3d 1390 (11th Cir. 1995)(76 AFTR2d 95-5139, 95-2 USTC [paragraph] 50,351), aff'g 103 TC 721 (1994).
(16) Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
(17) See generally, Weinstock, Planning an Estate (Shepard's/McGraw-Hill, Inc., 4th ed., 1995 and 1996 Cum. Supp.), [subsections] 4.35, 4.36.
(18) Anthony A. Mercurio, TC Memo 1995-312; no deduction is allowed if the payments are construed to be child support.
(19) Wofford, Divorce and Separation, 515 T.M., p. A-36.
(20) See Harris, "Tax Planning for the Personal Residence in the Context of Divorce and Remarriage," 24 The Tax Adviser 665 (Oct. 1993), p. 671.
(21) Truett E. Allen, 72 TC 28 (1979).
(22) Bolaris' note 11.
(23) Wofford, note 19, p. A-35
(24) Rene A. Shegler, Jr, TC Memo 1964-57.
(25) Jean L. May, TC Memo 1974-54; Carlos Marcello, 380 F2d 499 (5th Cir. 1967)(19 AFTR2d 1700, 67-2 USTC [paragraph] 9516), cert. denied.
(26) Jeanne G. Snowa, TC Memo 1995-336.
(27) Rev. Rul. 75-238, 1975-1 CB 257.
(28) IRS Pub. 523 (1995), Tax Information on Selling Your Home, p. 12.
(29) See Harris, note 20, p. 673.
(30) Sec. 1034(a) requires the purchase of a replacement residence. IRS Letter Ruling 8029088 (4/25/80) states that only the sale of an entire interest in a residence (as opposed to, e.g., a remainder interest) qualifies under Sec. 1034; see Harris, note 20, p. 673.
(31) See Regs. Sec. 1.121-2(b)(2), Example (3).
RELATED ARTICLE: EXECUTIVE SUMMARY
* The one-time Sec. 121 $125,000 grain exclusion on the sale of a principal residence is just that: a taxpayer who has made or consented to that election can never make or consent to it again.
* A surviving spouse's bass in a marital residence depends on how the couple owned the home--as community property, joint tenants (tenants by the entirety) or tenants in common.
* The Sec. 121 gain exclusion hinges on passing an age test and an ownership/use test.
Hilari D. Pickett, M.Acc. Provo, Utah
Robert L. Gardner, Ph.D. Associate Director and Robert J. Smith Professor School of Accountancy and Information Systems Brigham Young University Provo, Utah
G. Fred Streuling, Ph.D. J. Earl and Elaine B. Garrett Professor School of Accountancy and Information Systems Brigham Young University Provo, Utah
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|Author:||Streuling, G. Fred|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1997|
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