The Primary Residence Exclusion

By Garrett Sutton

One of the greatest tax gifts is the principal residence rules for capital gains on the sale of your home. So great is the principal residence tax exclusion that even married couples filing jointly are benefited to the same, if not greater, extent as single taxpayers. Now, some people may argue that there have been, are and will be greater gifts, but not much beats the simplicity of this rule. The basics of it are immensely easy to grasp: you own a house, you live in it for at least two years, you sell it and you don’t pay any taxes on the gain. Gone are the days when the young homeowner (not wishing to sell and upgrade) had to save every receipt for every upgrade, every repair, every minor item bought at the hardware store. If you have lived in your own home for two years, you probably don’t have to worry.

Of course, there are some technicalities associated with the general rule. They are pretty simple so first I will bullet-point the main ones:

• If you are single your capital gains exclusion is limited to $250,000.00
• If you are married your capital gains exclusion is limited to $500,000.00
• You have to own the home and it has to be your “primary residence” for two of the previous five years

What is your “primary residence”? Basically, it is a home that you personally live in the majority of the year. If you have a house in Palm Beach and one in Lake Tahoe and you spend 8 months of the year at the Tahoe home than that is your primary residence. But, keep in mind the 2 out of 5 part of the rule. Let’s say that the next year you spend 7 months at the Palm Beach house. Then the Palm Beach home is your primary that year. See where I am going with this? You can primary more than one home at once over a five year period so long as each is your main home for at least two years during that five year period. Temporary absences are also counted as periods of use – even if you rent the property during those absences (but talk to your accountant about recapturing any rental depreciation).

Now don’t let the five year requirement confuse you – it only takes two years to achieve the tax exclusion. The five year part is a bonus, allowing you some freedom. You don’t have to personally use the home as your primary residence for two consecutive years or for the two years immediately before you sell, you just have to use it is your primary residence for two of the previous five years. But, it is also a limitation, you cannot live in a house for two years and then rent it for four years and then get the exclusion. You could live in it for two years and then rent it for three years and then sell it (so long as it is sold within the five year mark from when you first lived in it as your primary residence).

Also, bear in mind that married couples do not have to live together. So long as one spouse lives in the primary residence for the two years than the couple can take advantage of the $500,000.00 exclusion. But, they cannot primary two homes at once and get the $500,000.00 exclusion on both. If they live apart during the two year period and each sell their primary then they are each limited to the single taxpayer exclusion of $250,000.00 for each house.

If you have a home office or rental as part of your primary residence or run a business out of a portion of your property, your ability to maximize your capital gains exclusion largely depends upon whether the home office, business or rental was part of your home (in the same dwelling unit) or a separate part of your property (a separate building or apartment). If the business use of your home was contained within your dwelling unit then upon sale you will need to recapture any depreciation taken for that part of the home. But you will not lose any of the allowable capital gains exclusion ($250,000.00 for single taxpayers and $500,000.00 for married filing jointly). If the business use of your home was not a part of your dwelling unit then you need to bifurcate the sale by allocating the basis of the property and the amount realized upon its sale between the business or rental part and the part used as a home.

Remember, only one home can be sold in any two year period unless you and your spouse live apart, and even then you can each only take the single payer exclusion of up to $250,000.00. But what if you need to sell a home that you have not lived in for the full two years? The IRS tells us that in special circumstances you can sell a home before you reach the two year mark and get a pro-rated exclusion. An example of a pro-rated exclusion is, for example, if you are a single taxpayer and have to sell your primary residence for a qualified reason after living in it only one year than you could exclude up to $125,000.00. In other words, you lived in the home 50% of the requisite time so you can take 50% of the allowable exclusion. The special circumstances that qualify you for this safe harbor and allow you to take the pro-rated exclusion have to do with health (yours and certain qualified individuals such as close relatives), change of employment or what the IRS calls “unforeseen circumstances” (examples include death, natural or man-made disasters, multiple births form the same pregnancy, divorce) These circumstances also have to cause you to sell your home. Factors used by the IRS to determine causation include:

• Your sale and the circumstances causing it were close in time,
• The circumstances causing your sale occurred during the time you owned and used the property as your main home,
• The circumstances causing your sale were not reasonably foreseeable when you began using the property as your main home,
• Your financial ability to maintain your home materially changed, and
• The suitability of your property as a home materially changed.

1031 Exchanges and the Primary Residence Rule

What happens if you do a like kind tax deferred exchange (also known as a 1031 exchange) of rental property or other property held for investment and then later decide to live in the property that was purchased? It is crucial to your 1031 exchange that both the property sold and the property purchased are held for investment. The property purchased must undergo a holding period before it is resold or converted into non-investment property. That holding period should be a year and a day to avoid audit. After you have complied with the “held for investment” requirement by, for example, renting the property if it is rental property, then what? Well, you could sell the property and pay your taxes on that sale and all previous sales that were perhaps in a series of exchanges or exchange and defer the tax once again, OR you could live in the house as your primary residence. If you have a had a series of gains that you have deferred this is a way to extinguish your tax debt forever - all you have to do is move into your investment property once the holding period for it qualifying as an investment is over.

Gaining the primary residence exclusion for property that was 1031 property isn’t as easy as the simpler primary residence rules talked about above, but it does allow you to take advantage of two loopholes at once! The main difference when primary residencing a 1031 exchanged property is that you actually have to hold the property for 5 years. The five year part here is a substantive rule, you cannot sell after only 2 years of ownership as you can if you were simply primary residencing a home that was not exchanged into. But that first year that you had to hold onto the home for investment goes towards the five year calculation. So, you rent it for two years and live in it for three, or vice-versa, so long as you kick the whole thing off with a one year rental period and live in it two of the remaining four years.

In this way, you can exclude up to a total of $500,000.00 worth of gain (if you are married filing jointly or $250,000.00 worth of gain if you are a single taxpayer) from the combined gains of the sale of the home you ended up living in as your primary residence, and any of the gains that you had previously 1031 exchanged. For example, say you purchased a duplex in May of 2000 for $150,000.00 and then in June of 2001 you 1031 exchanged the duplex (now worth $200,000.00) into a commercial building worth $200,000.00 (thus deferring $50,000.00 worth of gain). A few years later the commercial building is worth $300,000.00 and you do another exchange, this time into a nice single family home worth $350,000.00 (you have to put in an additional $50,000.00 to complete the purchase). You have now deferred a total of $150,000.00 worth of gain. Let’s say you then choose to rent the home for the first two years that you own it and then you later decide to move into the home. You then live in the house for three years at which point it is now worth $700,000.00 and you sell it for this amount. You and your spouse have now effectively wiped out not only the $350,000.00 gain from the sale of your primary residence, but the previous $150,000.00 worth of gain as well.