Residency Exclusion Time Periods; Documenting Residency Improvements

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, September 5, 1999

Copyright 1999 Robert L. Sommers, all rights reserved.

Question: After I moved into a new home, I rented my previous home for 2 years. May I sell my prior residence now and still use the residency exclusion?

Answer: Yes, if you meet the residency exclusion requirements. The exclusion applies to sales or exchanges of property owned and used as a principal residence for at least two of the past five years prior to sale, whether or not it is rental property at the time of sale. (Under prior law, the property had to be your principal residence at the time of sale.)

Unfortunately, I have read that, according to an IRS spokesperson, you could lose your residency exclusion if you rent your property for more than one year prior to sale, because the property is no longer your residence. This statement is wrong: Whether the property has been converted to rental property is irrelevant under the new exclusion. (Historically, oral advice from IRS has been incorrect approximately 25% of the time.)

Note: The residency exclusion prevents taxpayers desiring to convert a residence to rental property and then to exchange the rental for other investment property under the tax-free exchange provisions of IRC Sec. 1031. For example, if you are single with a huge gain, say $2 million, in a residence, the exclusion of $250,000 will reduce your capital gain to $1,750,000.

In that case, you may avoid the tax by structuring the transaction as a tax-free exchange, provided you first convert this residence to rental property. To be successful, you must flunk the residency exclusion’s ownership and use tests, usually by waiting more than three years after the conversion to engage in the tax-free exchange.

Question: My finance has owned and occupied her condominium as a residence for two years. We plan to marry and live in my residence (which I have owned and already occupied for two years) and then sell both properties. Assuming she sells her condo for a $100,000 profit and I sell my residence for a $400,000 profit, may we exclude the entire $500,000 gain?

Answer: No. The residency exemption applies when you own and live in a home for two of the past five years. A spouse who owns a residence prior to marriage may sell that residence (subject to the residency exclusion rules) and claim up to $250,000 in profits tax-free. However, you cannot take advantage of the $500,000 rule for your home if your spouse sold her condo within two years of your sale.

Each of you may exclude only up to $250,000 on each residence (as though you both were single). You’ll have a $150,000 taxable gain ($400,000 gain less $250,000 exclusion) and your spouse’s unused $150,000 exclusion ($250,000 exclusion less $100,000 gain) cannot be applied to shelter your profits.

Consider selling the condo then waiting at least two years to sell your residence. That way, you’ll be entitled to exclude up to $500,000 in profits. Remember, you must file a joint return to claim the $500,000 exclusion and your spouse must have lived in your residence for at least two years.

Question: I’ve made capital improvements to my residence, but my bank does not send me cancelled checks. Down the road 20 years, how can I establish my residence’s basis, absent these checks?

Answer: The new residency exclusion of $250,000 for single and $500,000 for married couples was supposed to eliminate record-keeping hassles. But with Bay Area real estate prices increasing so rapidly, savvy home owners should be concerned with documenting their adjusted basis, in case the appreciation outstrips the exclusion.

Suppose you are single and purchased a $300,000 home now worth $600,000. If you improved your home by $50,000, then your adjusted basis would be $350,000 and the $250,000 profit would be tax-free. Otherwise, you would owe tax on $50,000.

Keep all invoices, marked with the date and check number, and retain your bank statements, as evidence that the invoice was paid. On most renovations, the building permit can also serve as evidence of the completed improvements.

Remember, under the new burden of proof rules for evidence in court proceedings, you must comply with reasonable requests for documentation by IRS, but if you do not have cancelled checks and cannot obtain them from the bank (say 20 years later), in general, the burden of proof shifts to IRS to prove you wrong.


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