Selling a principal residence after the TRA '97.
After nearly half a century, Congress has remodeled the tax rules for homeowners who plan to sell a principal residence. The Taxpayer Relief Act of 1997 (TRA '97), Section 312(b), repealed the Sec. 1034 rollover provisions, which allowed taxpayers to defer the gain on a sale or exchange of a principal residence to the extent the sales proceeds were reinvested in a new residence. TRA '97 Section 312(a) repealed the Sec. 121 once-in-a-lifetime $125,000 gain exclusion on the sale of a principal residence for taxpayers age 55 and over. Sec. 121 (b), as amended, permits individuals meeting ownership and use tests to exclude from taxable income up to $250,000 of gain ($500,000 if married filing jointly) each time they sell or exchange their principal residence.
Many taxpayers will benefit greatly from these changes; the tax consequences on the sale of a principal residence will be eliminated for nearly 99% of all Americans selling their homes.(1) Thus, taxpayers who move to a less expensive home, relocate to a less costly area or decide to rent may no longer be required to recognize gain on the sale of their personal residences. Other taxpayers will find little or no tax benefit under the TRA '97 on the sale of their principal residences (e.g., homeowners experiencing a loss on sale). Homeowners with gains in excess of the exclusion amounts, and those using their principal residence in part as a rental or business property, will no longer find favorable deferral provisions in the Code. However, the TRA '97 does create a category of transition taxpayers who can choose between applying (1) pre-TRA '97 Sec. 1034 or 121 and (2) post-TRA '97 Sec. 121.
This article explores the TRA '97 provisions, explains the rules for certain transition taxpayers under the new law, and provides planning suggestions for maximizing the tax benefits associated with the sale of a principal residence.
Pre-TRA '97 Secs. 121 and 1034 required careful navigation to maximize the gain deferral or exclusion.(2) Generally, Sec. 1034(a) allowed for gain nonrecognition on the sale of a principal residence, if (1) the purchase price of the new residence was at least as much as the adjusted sales price of the old and (2) the new residence was occupied by the taxpayer beginning within two years before and ending within two years after the sale of the old residence. Any gain not recognized under Sec. 1034 reduced the taxpayer's basis in the new residence under Sec. 1034(e).
Pre-TRA '97 Sec. 121 allowed a taxpayer age 55 or older, to exclude from gross income up to $125,000 of the gain realized on the sale of a principal residence, as long as the residence was used as his principal residence for at least three of the five years immediately before the sale. This election was available to a taxpayer only once during his life. Because Sec. 121(c) required married couples to make the election jointly, this provision often created complex and inequitable predicaments for widowed or divorced senior citizens who desired to remarry and one of the new partners had previously made the election with a former spouse.
The TRA '97
In general, the new Sec. 121 exclusion is allowed for each sale or exchange of a principal residence that has been treated as a principal residence for at least two of the preceding five years. The taxpayer must have owned and used the property as his principal residence for at least two years during the five-year period ending on the date of the sale or exchange ("ownership/use tests"). According to Sec. 121(b)(3) (A), the exclusion is allowed each time a taxpayer who sells or exchanges a principal residence meets the eligibility requirements, but generally no more often than once every two years. For a taxpayer who acquired his residence in a transaction covered by pre-TRA '97 Sec. 1034, new Sec. 121 (g) provides that the periods of ownership and use of the prior residence are taken into account in determining ownership and use of the current residence.
Example 1: S, who is single, sold her principal residence of 10 years on May 1, 1996 and deferred gain recognition under Sec. 1034. On the same day, S purchased and occupied a new residence, which she sold on Sept. 1, 1997. Under post-TRA '97 Sec. 121 (g), S's holding period in, and use of, her new residence is 11 years, four months. S qualifies for an exclusion of up to $250,000 of gain when she sells the new residence.
According to Sec. 121(c), if the ownership/use tests are not met for certain reasons, the exclusion is based on a ratio of the number of qualifying months to 24 months.(3) Specifically, under Sec. 121 (c) (2) (B), a taxpayer is entitled to a prorated exclusion if he fails to meet the ownership/use tests because of a change in place of employment, health or other unforeseen circumstances.(4) The prorated amount is the ratio of the aggregate amount of time the taxpayer actually owned and used the property as his principal residence during the five-year period (or, if shorter, the amount of time since the most recent prior sale to which the exclusion applied) to two years.(5)
Example 2: R, age 36 and single, purchases and occupies a principal residence in Jackson, Miss., on July 1, 1998. On Jan. 1, 1999, R is transferred by his employer to Houston, Tex. R sells his home on that date to his employer at a $75,000 gain. Because R is transferred due to unforeseen circumstances prior to the required two years, k can exclude $62,500 of gain (6 / 24 X $250,000) Thus, $12,500 of the gain will be taxable to R.
Example 3: The facts are the same as in Example 2, except that R is transferred overseas in January 1999 for five years, during which time the house is rented. When R returns, his employer transfers him to Fort Myers, Fla. If R sells his home in Jackson without reoccupying it, he is not eligible for an exclusion, as he did not live in it during the last five years. Under pre-TRA '97 law, R would have been able to defer the gain.
Under Sec. 121 (d) (2), the ownership/use tests are also met when an unmarried individual includes the period during which his deceased spouse owned and used the property before death.
Example 4: B and R were married in January 1996, and have since resided in B's residence of the past 10 years. B passed away on May 15, 1997; R sold the residence on Oct. 20, 1997. R passes the ownership/use tests; R does not individually meet these tests, but can include the 10 years during which B used the home as his principal residence.
Filing Status Issues
Under Sec. 121 (b) (2), the $500,000 exclusion applies to married couples filing jointly when either spouse meets the ownership requirement, both spouses meet the use requirement and neither spouse has had a sale in the preceding two years that was subject to the exclusion.
Example 5: T and V, both 35, married on Dec. 15,1997, at which time V joined T in his home of three years. In January 2000, they decide to sell the home and move into a new residence. If T and V file jointly, they can exclude up to $500,000 of gain on the sale. If they file separately, T can exclude up to $250,000 on the sale, because he meets the ownership/use tests.
A single taxpayer who marries a taxpayer who has used the exclusion within two years prior to the marriage would nevertheless be allowed a $250,000 exclusion.
Example 6: The facts are the same as in Example 5, except that V sold her home of five years in November 1997 and excluded the gain under post-TRA '97 Sec. 121 on the sale prior to moving into T's home; T's home is sold in January 1999. T and V can exclude up to $250,000 on the sale, because V previously elected to exclude gain under Sec. 121 within the previous two years.
Limiting the exclusion to one sale every two years does not prevent a husband and wife filing jointly from excluding up to $250,000 of gain from the sale or exchange of each spouse's principal residence, provided that each spouse would be permitted to exclude up to $250,000 of gain had the couple filed separate returns.
Example 7: The facts are the same as in Example 5, except that V sells her home of five years on March 3, 1998. T sells his home of three years on April 16,1998. In May 1998, V and T purchase a new home together. Each meets the ownership/use tests as to their former homes, so each is entitled to exclude up to $250,000 under post-TRA '97 Sec. 121 on the sale of the former residences on their 1998 joint return.
Once both spouses satisfy the eligibility requirements and two years have passed since the last exclusion was allowed to either, a full $500,000 exclusion is available for the next sale or exchange of their principal residence.
As mentioned previously, the TRA '97 creates a category of transition taxpayers who can choose between applying pre-TRA '97 Sec. 1034 or 121 or the post-TRA '97 Sec. 121 exclusion. In general, TRA '97 Section 312(d) provides that the exclusion is effective for sales of principal residences after May 6, 1997. A taxpayer may elect to be subject to the pre-TRA '97 rules if.
* The sale or exchange of the principal residence occurred prior to Aug. 5, 1997 (or after that date if pursuant to a binding contract in effect on Aug. 5, 1997) or
* The replacement residence was acquired before Aug. 5, 1997 (or pursuant to a binding contract in effect on Aug. 4,1997) and no gain on the sale would be recognized under pre-TRA '97 Sec. 1034.
This provision may be of particular interest to taxpayers who have gain on the sale of their principal residence in excess of the exclusion and are replacing their old home with a new one. Qualifying taxpayers should consider taking advantage of the prior Sec. 1034 rollover provisions when the cost of the new residence exceeds the new allowable exclusion plus their basis in their old residence.
Example 8: F and A, both under age 55, are married filing jointly. They purchased their current home for $250,000, and have owned and occupied it for 25 years. They sold it for $2,000,000 on June 1, 1997. Under post-TRA '97 Sec. 121, they will recognize a gain of $1,250,000 ($2,000,000 -- $250,000 basis -- $500,000 exclusion). If F and A timely reinvest in a new residence costing $300,000, they would not choose to apply Sec. 1034 under the transition rules because the recognized gain would be $1,700,000. On the other hand, if the cost of the replacement residence is $1,100,000, they will recognize a $90(,(00 gain; an election to apply Sec. 1034 under the transition rules would be beneficial.
Taxpayers who owned a principal residence on Aug. 5, 1997 and sell the residence before Aug. 5, 1999, but who fail to meet the ownership/use tests can still qualify for a reduced exclusion.
Example 9: J and O, ages 29 and 26, respectively, married on May 24, 1997; they bought their first home on July 1, 1997. On July 1, 1998, they sell it at a gain. Because they owned the home on Aug. 5, 1997, they are entitled to exclude $250,000 (12 / 24 X $500,000) of gain.
Taxpayers Age 55 and Over
Taxpayers age 55 and over who recently sold a principal residence and did not make a pre-TRA '97 Sec. 121 election may wish to consider amending their prior-year returns under Regs. Sec. 1.121-4(a) to make such election. This is particularly useful for taxpayers who opted to pay tax on any gain and reserve their pre-TRA '97 Sec. 121 exclusion for future use.
Consideration should also be given to taxpayers who may have invested in a replacement residence and deferred gain recognition under pre-TRA '97 Sec. 1034. Because gain deferred under that provision serves to reduce the taxpayer's basis in the replacement residence, amending a prior return now and making a pre-TRA '97 Sec. 121 election would effectively increase the taxpayer's basis in his replacement residence, potentially reducing future gain recognition. Thus, taxpayers electing to exclude gain under pre-TRA '97 Sec. 121 get a fresh start, with a new exclusion under post-TRA '97 Section 121.
Example 10: H and W, both age 58, sold their principal residence in 1995 for $200,000. Their basis in the home, purchased 30 years ago, was $125,000. If H and W recognized the $75,000 gain on their 1995 return, they may want to amend that return to elect gain exclusion under pre-TRA '97 Sec. 121, which will result in a refund. The gain excluded will not affect their basis in any replacement residence they may acquire. On the other hand, if H and W previously deferred the $75,000 gain under pre-TRA '97 Sec. 1034, they may want to amend their 1995 tax return to make a pre-TRA '97 Sec. 121 election and avoid the downward basis adjustment to their replacement residence that will carry over to post-TRA '97 years.
Change in Marital Status
The changes made by the TRA '97 recognize that taxpayers who marry, buy homes and subsequently divorce face many problems when dissolving their marriage, the least of which should be the tax ramifications on the sale of the personal residence. Thus, Sec. 121 (d)(3)(B), as amended, provides that divorced taxpayers who no longer reside in a principal residence may exclude up to $250,000 of gain, if the residence was the principal residence of either spouse at the time of a legal separation or divorce.
Example 11: D and T, ages 29 and 25, respectively, lived in a house owned by D until their divorce in 1996. Under the terms of the divorce agreement, T continued to live in the home until 1999, when it was sold for an $80,000 gain. D satisfies the ownership test and satisfies the use test through T's occupancy of the residence. Thus, D can exclude the gain under post-TRA'97 Sec. 121.
This provision is in stark contrast to the tax treatment of similar situations under pre-TRA '97 Sec. 1034. In Perry,(6) the taxpayer could not roll over his share of the gain from the sale of a residence he had lived in with his former wife, but in which he had not lived for almost four years before the sale.
The Perrys were divorced in late 1985; the ex-wife had the exclusive right, under the divorce settlement, to use the property until December 1987. At that time, the house was sold and the proceeds divided equally between the parties. The court found that Mr. Perry did not meet the use requirements under Sec. 1034 through his former wife's use of the property, denying him rollover treatment.
Taxpayers with Multiple Residences
Special consideration should be given to taxpayers with multiple residences; these homeowners should plan their occupancy of a particular residence to coincide with the ownership/use tests to avoid gain recognition.
Example 12: H and W, ages 52 and 49, respectively, are married filing jointly and own three residences: a family home in Indiana, a ski chalet in Colorado and a beach house in Florida. H and W ultimately plan to sell the family home and ski chalet and retire to the beach house. If they meet the ownership/use tests for the family home, they may sell it, exclude up to $500,000 of gain and move to the chalet. After meeting the ownership/use tests for that property, they may sell it, exclude the gain under post-TRA '97 Sec. 121, and retire to the beach house.
Loss of Indefinite Deferral
Homeowners with unrealized built-in gains exceeding the new exclusion face a tax on gain on the sale of their homes that previously could have been avoided under the rollover provisions. Thus, the new law may lock some taxpayers into the unenviable position of deciding whether to pay tax on gain exceeding the exclusion threshold on sale, or holding onto the home until death to possibly avoid gain. Taxpayers will no longer be able to indefinitely defer gains through a series of Sec. 1034 rollovers until the Sec. 1014 basis step-up at death.
Example 13: J and C, age 49 and 46, respectively, are married filing jointly. They have moved four times over the past 20 years, and each time deferred gain recognition under Sec. 1034. Although they paid $450,000 in 1993 for the house in which they have resided since 1996, their basis in the residence is only $75,000. If they sell their current residence in 2000 for $700,000, their gain is $625,000 ($700,000 - $75,000 basis), $500,000 of which may be excluded. If Sec. 1034 had not been repealed and J and C properly reinvested, they would have escaped gain recognition on the sale entirely. The only options available to J and C under post-TRA '97 Sec. 121 are to (1) sell and recognize a gain of $125,000 ($625,000 - $500,000) or (2) remain in the home until either spouse dies and possibly avoid gain recognition.(7)
Taxpayers should monitor the gain potentially taxable under post-TRA '97 Sec. 121 and be prepared to make decisions when it approaches the exclusion threshold. New strategies to avoid tax on the potentially taxable gain will likely emerge--e.g., a properly structured sale and leaseback may allow taxpayers to sell a personal residence, exclude any gain and continue to enjoy their home.
Reinvestment in a Cheaper Home
While the principal residence is the major asset of most middle-income taxpayers, many homeowners found little or no tax benefit under pre-TRA '97 Sec. 1034. Taxpayers who moved to a less expensive home, relocated to a less costly area, decided to rent instead of buy or had difficulty in finding a suitable replacement residence generally found Sec. 1034 problematic. Most were required to recognize all or part of the gain on sale. Post-TRA '97 Sec. 121 extends tax benefits to these middle-income taxpayers, because the gain exclusion does not depend on reinvesting the proceeds in a new home.
Form 2119, Sale of Your Home, was used to calculate any gain deferred under pre-TRA '97 Sec. 1034 and the basis of the replacement residence. Keeping Form 2119 and supporting records, in addition to records supporting any subsequent capital improvements, over long periods of time (often a lifetime) was necessary to properly compute and minimize gain recognition under Sec. 1034 on a later sale. The TRA '97 effectively ends such recordkeeping burdens for taxpayers who anticipate that gains on future sales will fall within maximum exclusion amounts.
However, there are still many excellent reasons to maintain good records. Recordkeeping is now more important for homeowners with sales in excess of the exclusion thresholds, because these taxpayers will be taxed on the excess gains. Taxpayers who sell their homes for an amount exceeding the exclusion threshold, but who realize no gain on such sale, should maintain adequate documentation of their basis in the residence sold. Future changes in marital status (due to death or divorce) may reduce the maximum exclusion amount from $500,000 to $250,000 for some taxpayers. Taxpayers claiming deductions for a home office or rental of a portion of the residence should continue to maintain records supporting such deductions. Also, to the extent post-TRA '97 Sec. 121 is modified or eliminated in the future, adequate records may facilitate favorable tax planning concerning the sale of a principal residence.
The TRA '97 resolves the conflict the Service has had with the Ninth Circuit's decision in Bolaris.(8) In Bolaris, the taxpayer vacated his residence and moved into a new house. While the taxpayer tried to sell his former residence, he intermittently rented it, deducting depreciation and other rental expenses; he eventually sold it. He successfully claimed Sec. 1034 nonrecognition for all of the sale gain, including that attributable to depreciation.
Under Sec. 121 (d)(6), as amended, taxpayers using their principal residence in part as a rental or business property will be required to recognize gain currently on the sale of the property to the extent of depreciation taken allocable to periods after May 6, 1997. This provision affects real estate investors and taxpayers who rent out a portion of their homes or claim home office deductions.
Gain Exceeds Exclusion
Certain taxpayers stand to be taxed on gains under post-TRA '97 Sec. 121 that would have been tax-deferred under pre-TRA '97 Sec. 1034, including those investing in areas of the US. with relatively high property values. Even a modest percentage increase in the appreciation of a home could produce a gain that is now subject to post-TRA '97 Sec. 121.
Example 14: L, single and age 40, invested in a principal residence in New York in 1983. L paid $600,000 for the home, which she recently sold for $950,000. If L reinvested appropriately, she would recognize no gain currently on the sale of the residence under pre-TRA '97 Sec. 1034. Under post-TRA '97 Sec. 121, however, L has a taxable gain of $100,000 ($950,000 - $600,000 - $250,000 exclusion).
Lower Capital Gains Rates
For taxpayers who will be required to recognize gain on the sale of a personal residence, the tax bill has been somewhat softened. Under TRA '97 Sec. 311 (a), the tax on most capital gains has dropped to a maximum of 20% for assets held longer than 18 months, and as low as 18% for homes held longer than five years (beginning in 2001).(9) Taxpayers depreciating all or a portion of their personal residence will pay a 25% rate on the part of the gain due to depreciation.
While the TRA '97 may not be a fundamental benefit to all taxpayers, the separation of the gain nonrecognition rule from the reinvestment requirement will offer more choices to taxpayers who sell a principal residence. The impact of these rules will allow older couples to exclude their gain and keep more of the funds for retirement and elder care needs. Thus, homeowners who sell their homes for retirement income, move into a smaller apartment or move in with a family member will benefit from these changes. In addition, most middle-class families changing jobs and moving to communities with lower housing costs will be able to exclude the entire gain and use the money saved by trading to a lower-priced home. Further, inner-city and rural communities with low housing costs could become more attractive to those wishing to purchase a home in those areas; sellers could keep some of the gain on sale of their current homes for other purposes. Finally, for a majority of Americans, these revisions will greatly reduce the recordkeeping requirements associated with keeping track of basis in a principal residence.
(1) Treasury Dep't News Release RR-1474 (2/1/97).
(2) See Pickett, Gardner and Streuling, "Maximizing Gain Exclusion/Deferral When Selling a Principal Residence Due to Death, Divorce or Marriage," 28 The Tax Adviser 90 (Feb. 1997).
(3) Sec. 121 (c) does not state how to compute the ratio. Until further guidance is issued, the use of either days or months would appear to be a reasonable basis for making the computation.
(4) Currently, "change in place of employment, health, or unforeseen circumstances" is not defined. Presumably, "change in place of employment" refers to an employment change meeting the time and distance requirements of Sec. 217.
(5) Under Sec. 121(d)(7), an individual who receives licensed care out-of-residence on account of physical or mental incapacity can include time spent in such residence as part of the two-year use requirement, if certain other rules are met.
(6) Curtis B. Perry, 91 F3d 82 (9th Cir. 1996) (78 AFTR2d 96-5797, 96-2 USTC [paragraph] 50,405), aff'g TC Memo 1994-247.
(7) Generally, the gain avoided at death is a function of applicable state law, including manner of ownership of the property and community property law versus common law considerations, the gain on subsequent sale and the allowable exclusion, as affected by filing status in the year of sale.
(8) 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).
(9) The capital gains rates are discussed in Bukofsky and Sherr," Diverse Planning Opportunities Available Under the TRA '97 (Part I)," 29 The Tax Adviser 18 (Jan. 1998).
RELATED ARTICLE: EXECUTIVE SUMMARY
* The TRA '97 creates a category of transition taxpayers who can choose to apply (1) pre-TRA '97 Sec. 1034 or 121 or (2) post-TRA '97 Sec. 121.
* There are a number of exceptions to meeting the ownership/use tests.
* A $500,000 exclusion is available only if married filing jointly; it is $250,000 for all other taxpayers.
Nell Adkins, Ph.D., CPA Assistant Professor of Accounting College of Business Administration University of Houston Houston, Tex.
Gregory G. Geisler, Ph.D., CPA Assistant Professor of Accounting College of Business Administration Georgia State University Atlanta, Ga.
Steven C. Thompson, Ph.D., CPA Professor of Accounting College of Business Florida Gulf Coast University Fort Myers, Fla.
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|Title Annotation:||Taxpayer Relief Act of 1997|
|Author:||Thompson, Steven C.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1998|
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