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One time only!! Excluding capital gains on home sales.

With the passage of the Tax Reform Act of 1986, several commonly used and popular tax deductions were either eliminated or substantially modified. One source of tax benefits that for the most part survived tax reform are those related to home ownership. Both home owners and sellers are able to take advantage these benefits to lower their annual tax liability and defer taxes on realized capital gains, respectively. Particularly for owners, mortgage interest and property tax expenses can constitute a significant portion of one's annual itemized deductions.

Home sellers also enjoy tax benefits. Among them are the deferral of tax on capital gain for sellers who reinvest the proceeds into a new principal residence and the one-time exclusion of up to $125,000 in capital gain for sellers 55 years or older at the time of sale.

One important difference between these two benefits is with respect to the seller's options in using these benefits. Unlike the mandatory deferral-of-gain provisions of Internal Revenue Code (IRC) Section 1034, the exclusion of gain on the sale of one's residence must be elected and is available only once.

This article focuses on the second benefit, the provisions of which are contained in IRC Section 121 (hereafter referred to as Code Section 121). It should be noted that in addition to qualified individuals, Code Section 121 also applies to qualified trusts. The type of trusts qualifying for the exclusion will also be discussed.

A Brief History of Code Section 121

Tax legislation has encouraged taxpayers to "buy up" when purchasing principal residences. The typical homeowner buys his or her "starter house" at a relatively early age, perhaps makes capital improvements to the residence, outgrows the house with the addition of more family members, sells it at a profit and buys a larger residence.

This process of purchasing more expensive (and perhaps larger) residences may be repeated indefinitely with several prerequisites for deferring tax on the realized gain from their sales. Under the provision of IRC Section 1034, tax on the realized gain from the sale of a principal residence will be deferred provided that the purchase price of one's new residence exceeds the adjusted sales price of the old residence. Other restrictions listed in IRC Section 1034 apply as well.

Through the years, tax on the realized gain from the sale of any number of principal residences can be deferred indefinitely provided the requirements of IRC Section 1034 are met. At a certain point, however, buying a larger residence or maintaining one's current residence may not be feasible, especially if the taxpayer is elderly and the majority of family members have "left the nest." Consequently, the taxpayer will sell and buy a less expensive (and smaller) home or move into a rental apartment. After deferring tax on the realized capital gain from the sale of these residences, the taxpayer could face a huge tax liability.

Congress understood the potential problems confronting these taxpayers. It therefore enacted Code Section 121 to relieve or reduce this possibly large tax liability.

Prior to 1978, taxpayers 65 years and older at the time of sale were eligible to exclude all gain on the sale of a principal residence if the adjusted sales price was $35,000 or less. In 1978, the age requirement was changed to 55 years or older at the time of sale and the maximum exclusion was increased to $125,000. These changes were made by Congress to shelter taxpayers from rapidly spiraling property values and to reflect the increasingly earlier age of retirement. Since 1978, neither the age requirement nor the limit on capital gain exclusion has been modified.

Specific Requirements of Code Section 121

Code Section 121 lists specific requirements. They are: * The taxpayer (or spouse) must be 5 5 years or older at

the time of the sale. * Amounts up to $125,000 of capital gain may be

excluded. For taxpayers filing as married filing separately,

both spouses may exclude up to $62,500. * The taxpayer (or spouse) must have owned the residence

and used it as his principal residence for at least

three out of the five-year period preceding the sale. A

taxpayer who becomes physically or mentally incapable

of self care and who owned and used a residence

as his or her principal residence for at least one year

during the five-year period will have fulfilled this


Several questions arise when analyzing these requirements. They include: * Can spouses who file as married filing jointly--neither

of whom individually qualify for the Code

Section 121 exclusion but collectively qualify for the

exclusion--"divide" the requirements between them

in order to jointly exclude the sale of their jointly-owned

residence? * How does a divorced couple contemplating the sale

of their jointly-owned residence use Code Section

121 to their tax advantage? * If several unmarried individuals own a residence as

tenants in common, can each eligible individual

exclude his or her portion of capital gain upon sale of

the residence? * Can the exclusion be rescinded? * If the full amount of $125,000 is not used on one

sale, can its balance be used on a subsequent sale? * Can one ownership-and-use period be "tacked on" to

another ownership-and-use period to fulfill the three

out of five year requirement?

We shall explore the answer to these and other related questions.

Age Requirement

A taxpayer who has lived in his or her principal residence for at least three out of the last five years must be 55 years or older at the time of sale of the principal residence in order to use the $125,000 capital gain exclusion. In other words, simply turning 55 in the year the property is sold does not fulfill the age requirement. For example, a taxpayer who sells a principal residence in May will not be eligible to use the capital gain exclusion if he or she turns 55 in June.

The age requirement is easy to understand if an unmarried individual owns a residence, but what about a married couple? Do both spouses (who have lived in the residence for the required amount of time) have to meet the age requirement?

The answer to this question depends on the couple's filing status. If the couple files as married filing jointly, then only one spouse needs to meet the age requirement. (However, as described below, this same spouse must also meet the residency requirement.) On the other hand, if the couple files as married filing separately, then each spouse must meet the age, use and ownership requirements in order to exclude up to $62,500 (per spouse) of capital gain.

Ownership and Use Requirement

A taxpayer must have owned and used the property as his or her principal residence for a total of at least three years during the five-year period ending on the date of sale. The term "principal residence" has been used throughout this paper. It includes a house, condominium, cooperative unit, houseboat or housetrailer. It does not include one's summer vacation home or other property not used as a principal residence. Furthermore, if a property is used partly as a principal residence and partly for other purposes (e.g., rental), then one must allocate the gain for the personal and business portions. The exclusion would then apply to only the portion of the gain allocable to the principal residence.

The ownership and use requirement need not be fulfilled concurrently. For example, a taxpayer occupied a rental apartment that later was converted to a condominium unit that the taxpayer purchased. In a revenue ruling,(1) the IRS stated that the use requirement was met because the length of time the taxpayer occupied the property (even though he or she did not actually own it) constituted a "use" period.

Generally, a taxpayer cannot "tack on" the ownership-and-use period from one residence to another. The only exception to this rule is a situation in which a residence is involuntarily converted (e.g., destroyed by fire or damaged by a hurricane) and replaced with "like kind" property within the statutory replacement period.(2) In that case, the taxpayer's use-and-ownership period for the old residence may be carried over and "tacked on" to the ownership period for the replacement residence.

In 1988, Congress modified the use test for taxpayers who become physically or mentally incapable of self-care and reside in any facility licensed by a state or political subdivision to care for an individual in the taxpayer's condition. Under these circumstances, for sales after September 30, 1988, the taxpayer must have lived in the property for at least one year during the previous five year period.(3)

Effect of Marriage and Divorce

In using the benefits of Code Section 121, one must determine his or her marital status as of the date of sale of his or her home. If one is legally separated under a decree of divorce or separate maintenance, then one is not considered married.(4)

If one is married when his or her main principal residence is sold, then a spouse must join in making the choice to exclude gain. This is the case even if: * The spouses own the home separately; * The spouses file as married filing separately; and * The spouse not owning an interest in the home has

not lived in it for the required time before the sale.

In a situation where a spouse died after the sale but before making the choice to exclude, then the personal representative (executor of the estate) must join with the surviving spouse in choosing to exclude gain. While in most cases the surviving spouse is the executor for the surviving spouse's estate, there are exceptions. For example, if a child is the executor for his or her parent's estate, then it may be in the child's best interest not to sell the residence and exclude gain.

This would typically occur where a residence was purchased several years ago and has escalated in value. If the child stands to inherit the property (and receive a "step-up" in basis), then there could be little or no realized gain once the child sells the property. Nevertheless, if there is a surviving spouse, the child must join with him or her in electing to sell the property and exclude gain.

Until now, we have assumed that the principal residence is jointly owned (tenants by the entirety or tenants with right of survivorship). However, where only one spouse owns a residence (e.g., in a non-community state where one spouse bought the residence prior to marriage and subsequently did not place the other spouse's name on the title to the house), then only the spouse who owns the property must meet the age, ownership and use tests. However, the other spouse must join in making the choice to exclude gain.

A married couple (not each spouse) is allowed the exclusion of up to $125,000. This rule has tax implications for couples who divorce or for a surviving spouse following a decision to exclude gain. As a result of excluding gain, neither spouse would be eligible to exclude gain with a future spouse who has not used his or her exclusion. The divorced couple or the surviving spouse, following the use of the exclusion, is "tainted" as far as the future use of Code Section 12 1. However, the choice to exclude gain may be revoked within the latest of: * Three years from the due date of the return for the

year of the sale; and * Three years from the date the return was filed; and * Two years from the date the tax was paid.

Both spouses, however, must join in the decision to revoke the exclusion.

Interestingly enough, if a couple divorce prior to the sale of a principal residence and both spouses' names remain on the title to the house, then each spouse would be entitled to exclude up to $125,000 capital gain when it is sold following the divorce. The divorced spouses (both of whom own a portion of the principal residence) would be treated as tenants in common. In short, each tenant may exclude up to $125,000 in capital gain. Similarly, if for example four people own a principal residence as tenants in common (and each tenant fulfills the age, ownership and residence requirements of Code Section 121), then up to $500,000 in total capital gain may be excluded following its sale. Each tenant would individually report his or her share capital gain exclusion (up to $125,000). Finally, in all situations there are no provisions for the carryover of the unused portion of the $125,000 exclusion after the election has been made. A taxpayer, therefore, may not exclude $25,000 in one year and $100,000 in a later year on the sale of two principal residences.

Couples who plan to marry and both of whom own principal residences (and have not previously excluded gain) should consider selling one or both residences prior to getting married in order to use both exclusions. If the couple waits and sell the residences after getting married, then only one exclusion would be permitted. This rule applies even if one elects to exclude gain on a separately owned residence or if the couple files separately.

Partial Dispositions, Estates and Trusts

No exclusion of gain from the sale of a residence will be permitted if the taxpayer does not dispose of the property in its entirety. For example, the IRS disallowed the exclusion where the taxpayer "sold" the property and retained a life estate(5) or remainder estate(6) in the property.

A surviving spouse who inherits title to a residence can claim an exclusion without personally meeting the ownership and use requirements. This would be valid only if the deceased spouse had satisfied the ownership and use requirements prior to death and had not previously elected exclusion. Also, the surviving spouse must be 55 years or older and must not have remarried at the time of the sale.

If the executor (a non-spouse) of an estate sells the decedent's residence, the executor cannot independently elect to exclude from the estate's income any gain realized on the sale. However, if the decedent met the age, ownership, and use requirements and had entered into a binding executory contract to sell his or her residence, then the executor may exclude gain.(7)

In general, in cases where a trust beneficiary has the power to transfer all of the trust assets to himself or herself, then he or she is considered as owner of the assets. Consequently, he or she may elect to exclude the entire gain from the sale of a residence held by the trust. The trust beneficiary, of course, must meet all of the requirements of Code Section 121.(8) However, where a trustee-beneficiary of a trust is only entitled to a certain proportion of the trust's assets, then only that same proportion of the capital gain may be excluded upon the sale of a principal residence held by the trust. Also, the transfer of title of the principal residence to a revocable trust will not preclude the grantors from taking advantage of Code Section 12 1, because by reserving the power to revoke, they are treated as owners of the trust.

On the other hand, a sale of a principal residence by the trustee of a bankruptcy estate cannot qualify for the Code Section 121 exclusion.(9) This is because the bankruptcy estate is a separate entity from the debtor. As a result of the bankruptcy trustee not meeting the Code Section 121 requirements for the sale of the principal residence included in the trust (e.g., the trustee would not meet the ownership and residency requirement), exclusion of gain is prohibited.

Summary and Conclusions

We have discussed and described some of the aspects of Code Section 121. In short, eligible taxpayers can exclude up to $125,000 of capital gain following the sale of a principal residence. While the prerequisites for excluding gain are fairly straightforward, some situations will require additional analysis (e.g., the sale of a residence which is used partially for personal living and partially for business or rental). The exclusion of capital gain, as well as the mandatory deferral-of-gain provisions of Code Section 1034, are two benefits available to home sellers. These provisions were not modified by the Tax Reform Act of 1986. Eligible taxpayers should also realize that both benefits may be used on the sale of the same residence and both would be reported (for the year of sale of a principal residence) on IRS Form 2119 (Sale of a Principal Residence).

The ramifications of the once-in-a-lifetime exclusion are different for every taxpayer. Before entering into a contract to buy or sell a principal residence, a taxpayer approaching or past the age of 55 should discuss the implications of Code Section 121 with his or her tax advisor in order to possibly maximize both present and future tax savings.


(1) IRS Revenue Ruling 80-172 (2) Internal Revenue Code Section 165 (3) Internal Revenue Code Section 121 (d) (9) (4) Internal Revenue Code Section 6013 (d) (5) IRS Letter Ruling 8029088 (6) IRS Letter Ruling 8246123 (7) IRS Revenue Ruling 82-1 (8) IRS Letter Ruling 8221147 (9) In re Mehr, Bankruptcy Court, New Jersey

Edward A.Zurndorfer, EA, is enrolled to practice before the Internal Revenue Service. He is also accredited in accountancy and taxation by the Accreditation Council for Accountancy and Taxation (ACAT). A member of NSPA, he has published several articles on individual and small business taxation in professional tax journals.
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Author:Zurndorfer, Edward A.
Publication:The National Public Accountant
Date:Oct 1, 1993
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