The sale of a principal residence is probably the most significant tax transaction most taxpayers will encounter. When a residence is sold, the rules for determining the potential gain - its deferral or exclusion by persons aged 55 or older - are often interrelated and complex. When a portion of the principal residence is also used for a business or as a rental unit, allocations between the business and non-business portion of the residence must be made. If a married couple owns the residence, their marital status at the time of purchase and sale may cause allocation problems as well. With the elimination of the capital gains deduction for individuals commencing in 1988, the provisions deferring tax on the sale of a residence and the exclusion of gain by persons aged 55 have increased in importance.
When property is sold, Internal Revenue Code Sec. 1001 determines the amount of gain or loss realized and recognized for tax purposes. The computation for gain is the amount realized minus the adjusted basis; the computation for loss is the adjusted basis minus the amount realized.
The amount realized is the sum of money and the fair market value of other property received by the seller, minus selling expenses. Relief of indebtedness (such as mortgage which is assumed by the purchaser) is considered money received.
The adjusted basis measures the "tax cost" of the property owned by the seller. It is generally the cost paid by the taxpayer, plus the costs of any capital expenditures or improvements made to the property, minus any depreciation deductions taken. The cost is generally the amount paid for the property, including any indebtedness which the taxpayer assumes as part of the original purchase.
The amount recognized is the "profit or loss" on the transaction. The entire amount of the gain or loss realized will be recognized in the year of sale and treated as gross income (or as a deduction from gross income if there is a loss permitted under the Code), absent a specific non-recognition or exclusion provision.
Non-recognition provisions defer the recognition of gain, making the present transaction non-taxable, but preserving the gain until the property received is disposed of in a subsequent taxable transaction. An exclusion provision applies to a presently taxable transaction in which the gain is specifically excluded from the taxpayer's gross income.
Sec. 1034 is a non-recognition provision which involves the replacement of a principal residence ("old residence") with another principal residence ("new residence"). If Sec. 1034 applies, the taxpayer rolls over the gain from the sale of the old residence into a new residence, and this process will continue through successive sales until a sale occurs in which Sec. 1034 does not apply.
Under Sec. 1034, if the taxpayer: (1) sells the old residence and acquires a new residence; and (2) the acquisition of the new residence occurs within 2 years of the sale of the old residence (NOTE: the new residence can be acquired up to 2 years prior to the sale of the old residence); then (3) Sec. 1034 will apply to the extent the cost of the new residence exceeds the adjusted sales price (discussed below) of the old residence. NOTE: The comparison is between the adjusted sales price of the old residence and the cost of the new residence.
NOTE: There is no tracing of proceeds from the sale of the old residence to the acquisition of the new residence. The old residence could be sold on an installment basis and the new residence could be purchased for cash from savings or from borrowed funds.
Sec. 1034 contains a limitation to prevent the rapid purchase and sales of residences under the provision: There must be at least 2 years between each sale of a residence.
A replacement residence may be constructed, if it can be completed within the 2 year replacement period. If the deadline is not met, only costs incurred during the replacement period will qualify as costs of the new residence. Rehabilitating an existing house by remodeling a kitchen or adding rooms is also permitted.
A principal residence is the home in which the taxpayer lives. It includes the conventional single family home, condominium or cooperative, a mobile home or a duplex. If the taxpayer has more than one residence, it is the home in which the taxpayer lives most of the time.
NOTE: Sec. 1034 does not apply to the sale of a second residence, vacation homes or investment properties, even if the proceeds are invested in a principal residence. Similarly, Sec. 1034 does not apply to the sale of a principal residence unless another principal residence is purchased.
The taxpayer must have an ownership interest in the residence; property in which the taxpayer resides, but in which legal title is held in the name of another family member (other than a spouse) or in trust (unless the taxpayer is considered the owner of the trust) will not qualify as a residence.
If a residence is used partially for business or is rented out as an investment, the taxpayer can still claim the portion used for personal living as a residence. An allocation is made between residential and business use, and only the portion allocated to residential use will qualify under Sec. 1034.
NOTE: With the elimination of the capital gains deduction for individuals beginning in 1988 and the new restrictions on "home office" deductions, continued business use of a residence should be reconsidered.
The taxpayer does not have to live in the residence prior to its sale and may rent it out, provided the residence could not be sold due to circumstances beyond the taxpayer's control, for example: a declining real estate market, no mortgage money available, doubt as to whether a new job will work out, a temporary foreign assignment or adverse rent control laws. The focus is on whether the taxpayer intended to convert the residence into income producing property (investment property) rather than to sell it. This rule also applies if the taxpayer acquires a new residence prior to selling the old residence and temporarily rents it out.
In order to prevent an inadvertent gain, husbands and wives must make a special "consent" election (Form 2119) when either spouse contributed more than 50% of his or her separate funds for the purchase of either the old residence or the new residence. This situation usually occurs when one spouse owned the residence prior to marriage.
If a married couple jointly acquired a residence and the residence is sold while they are living apart, Sec. 1034 will apply, but each spouse is considered a 50% owner of the old residence. Therefore, the cost of the new residence purchased by each spouse must be greater than 50% of the adjusted sales price of the old residence in order for Sec. 1034 to apply in full.
The adjusted sales price is the amount realized, minus fixing up expenses.
Amount realized: The amount realized is the sum of money (plus the fair market value of any property) received for the sale of the residence, minus selling expenses (such as commissions, advertising expenses, document preparation and legal services incurred in connection with the sale).
Fixing up expenses: Fixing up expenses are expenditures to prepare the old residence for sale such as painting, wall papering and repairs. The deduction is available only if (1) the work was performed within 90 days from the date the sales contract for the old residence was signed, and (2) the expenses are paid no later than 30 days after the date of sale. The IRS has ruled that fixing up expenses are not deductible if the sales contract expires; a later sale will not cure the defect.
NOTE: Capital expenditures and improvements (generally expenditures which have a useful life over one year such as the installation of air conditioning, a new roof, furnace or fireplace) are not fixing up expenses, but are added to the basis of the old residence.
The cost of a new residence includes:
The basis in the new residence is its cost, reduced by the amount of gain which is not recognized by virtue of Sec. 1034.
Assume that in 1960 a taxpayer purchased a residence for $25,000 (for $5,000 in cash and a $20,000 mortgage) and made $15,000 worth of improvements. In 1987, the old residence was sold for $240,000, there were fixing up expenses of $5,000, commissions of $13,000. advertising costs of $1,000 and legal fees of $1,000. A new residence was purchased within 2 years for $210,000 (for $40,000 in cash and a $170,000 mortgage). Additionally, within the two year period, the kitchen in the new residence was completely remodeled for $20,000.
Taxpayers who are 55 years or older may elect to exclude up to $125,000 of gain from the sale or exchange of their principal residence, provided: (1) the taxpayer is 55 or older before the date of the sale; (2) the taxpayer owned and used the property as a principal residence for at least 3 of the previous 5 years prior to the sale (although the period does not have to be continuous); and (3) the sale must have occurred after July 26, 1978. The focus is on the date the sale is made, not when the payments are received.
The same facts as in Example #1 except Sec. 121 applies and a new residence is not purchased:
The taxpayer who conveys a principal residence into a revocable trust is considered the owner of the residence. If a life estate is owned, the taxpayer is considered the owner of the residence for purposes of Sec. 121, but if the taxpayer with a fee simple interest sells the life estate and retains the remainder interest, Sec 121 is not available.
The 3 year period is met if the taxpayer owned and used the property as a principal residence for either 36 full months or for 1,095 days. Short periods of absence, vacations and seasonal absences are counted as periods of use, even if the residence is rented during the absences. The tests for a principal residence are the same as under Sec. 1034, including the rules regarding temporary rentals. The property does not have to be the principal residence on the date of sale.
Once a taxpayer or his spouse has made an election to exclude the gain under Sec. 121 after July 28, 1978, neither party can make a subsequent election; there is only one election per married couple. If a married couple each owned their principal residence prior to their marriage, and if both residences were sold during the marriage, the Section 121 election applies to only one of the residences.
If each sold their respective residences prior to marriage and elected Sec. 121, a subsequent marriage would not cause any recapture of the Sec. 121 exclusion. Determination of marriage is made on the date of sale; however, an individual legally separated under a divorce or separate maintenance decree is not considered married. If a married couple divorces after one of the spouses made the election during the marriage, no further election under Sec. 121 is permitted to either spouse or to any future spouse.
The amount excludable under Sec. 121 is $125,000; however, a married person filing separately is limited to $62,500. If a married couple files jointly and one spouse qualifies for the exclusion by reason of age, use of ownership, then the exclusion applies in full.
Where property is used partly in business and partly as a residence, the $125,000 exclusion applies only to the portion of the gain attributable to the residence. This allocation rule applies only if during the 5 year period preceding the sale of the residence, the business use occurred in more than 2 of those years. Unmarried joint owners of a residence are each entitled to the full exclusion under Sec. 121.
Once a taxpayer reaches age 55, Sec. 1034 and Sec. 121 may be combined. So long as a new residence is purchased for not less than $125,000 of the adjusted sales price of the old residence, there will be no gain recognized.
Using the same facts as in Example #2, except that the taxpayer purchases a smaller, new residence for $75,000 within the requirements of Sec. 1034:
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