Capital Gains Exclusions
As the IRS continues to refine the rules, it is important to have a plan for how you will cash out of your principal residence without giving all of your equity to the IRS. First of all, principal residence can be many different things--: single family residential home, condominium, mobile home, house trailer, tenant-stockholder cooperative housing unit—even a boat, as long as it has sleeping, cooking and bathroom facilities.
It can get tricky when you split your time between two different homes in any one year. Simply put, the IRS views your principal residence as the home you own and live in for “a majority of the time during the year.”
If there is a question regarding where you lived, the IRS may look at some of the following to determine your eligibility:
- the location of your home in relation to your place of employment.
- the location where your family members reside.
- the address you use on your federal and state tax returns, driver’s license, vehicle registration and voter registration.
- the mailing address you use predominantly for bills and correspondence.
- the location of your banks.
- the location of your “religious organizations and recreational clubs.” (REALLY? Wow...)
To add another layer, and one that can work in your favor: You can switch the "principal residence" designation from one residence to another each year to keep with your personal tax strategies. For instance, if you own a house in Indiana and a condo in Arizona, and the condo has appreciated substantially, you’ll want to pocket as much as possible of that gain tax-free through a sale.
You can do this by making your Arizona condo your principal residence for two years running by living in it more than six months each year. That qualifies the condo for the maximum capital gains exclusion of $250,000 for single filers or $500,000 for joint filers if you sell the following year. You can leave Indiana New Years Day and just stay through June instead of coming back Memorial Day weekend. Presto! It's your principal residence.
You then switch your principal residence back to your house in Indiana. By living in that one for a majority of the time during each of the two years following the condo sale, it should also qualify for the maximum capital gains exclusion.
Also, thanks to the 1997 legislation, you no longer have to be concerned with replacing your residence with another house of equal or higher value within a certain time frame. There is no requirement for purchasing a replacement residence. Home improvement expenses are no longer a factor in determining the deferred gain with respect to a principal residence. With that change, taxpayers over age 55 are no longer eligible for that one-time exclusion of $125,000 of gain from the sale of a principal residence without that two-year rule attached. Everybody, regardless of age, plays by the same rules and enjoys the same benefit.
To take advantage of these capital gains exclusions mentioned above, note that they are applicable to only one sale or exchange every two years. And the home is not required to be the principal residence at the time of purchase or sale. I just has to meet ownership and use tests: you must have owned and used the residence as your principal residence for a total of at least two of the previous five years immediately preceding the sale or exchange. Note that it does not have to be consecutive years. You could live in the Arizona condo in 2019, and then again in 2022; as long as you sell it by the end of 2023 you should meet the requirement for the capital gain exclusion.
For married peeps, filing a joint tax return means you can qualify for the $500,000 exclusion provided at least one spouse meets the ownership test, both spouses meet the use test, and neither spouse is ineligible for the gain exclusion because he or she sold or exchanged a residence within the last two years and took the tax benefit. For those marrieds who don’t qualify for the $500,000 exclusion, they may still be able to use the $250,000 exclusion, or a prorated exclusion, if either spouse meets the ownership and use requirements.
There is military extension of the capital gains exclusion for households where one spouse is serving. This allows active-duty military members who are away from their property due to PCS orders to extend the 60-month period up to an additional 10 years. This means that eligible military members may exclude their capital gains as long as they occupied the primary residence for any two of the previous 15 years and they don't need to be two consecutive years.
Widowed spouses selling a residence generally are only eligible for the $250,000 exclusion on a tax return filed as a single person, surviving spouse, or head of household. However, they could be eligible for the entire $500,000 exclusion if the residence is sold during the tax year in which their spouse died, provided the sale is reported on a final joint tax return.
Divorcing spouses may be able to take full advantage of the $500,000 exclusion if you meet the two year requirement and the residence is sold as part of the divorce. There are also rules and allowances for many post-divorce scenarios where one spouse buys out the other, the jointly owned home wasn't owned for the full two years, or both spouses maintain ownership but only one continues living in the residence. Be sure these scenarios are well documented in your divorce settlement. You don't want to lose the tax benefit you're actually entitled to enjoy because you lack proper documentation. Ask your attorney how your specific scenario can be applied.
If a taxpayer doesn’t meet the ownership or residence requirements, a pro-rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. The amount of the available exclusion is equal to $250,000 or $500,000 multiplied by a fraction equal to the shorter of the number of months of the total of periods during which the ownership and use requirements were met during the five-year period ending on the date of sale, or the period after the date of the most recent sale or exchange to which the exclusion applied divided by 24 months.