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THE MARITAL RESIDENCE:

LEGAL ISSUES,

PRACTICAL SOLUTIONS

Putting it all Together

Steven L. Abel

for

Family & Divorce Mediation Council

of Greater New York

March 25, 2004

Example #5: Bob and Sue decided to split the sheets. In December 1998, Bob moved out of the home that they had both purchased in 1997. The divorce proceedings got ugly and complicated, and dragged on and on. While still legally married, Bob and Sue sold the home in November 2000. And, even though they filed a joint tax return for 2000, they will not receive the benefit of the full exclusion. Why? Because Bob did not use the home as his principal residence for at least two of the five years prior to the sale.....

Is this conclusion correct?

More facts: House purchase price: $200,000. Improvements cost $50,000. Sales Price: $700,000. Mortgage pay-off: $150,000.

Is Sue’s gain exempt?

Is Bob’s gain exempt?

TRUE OR FALSE?
Husband moved out, so it’s not his principal residence, so he must pay capital gains tax?

At age 55, you get a $125,000 capital gains tax exemption?

If you buy a new house, you can "roll-over" the capital gain and avoid the tax?

Our mortgage is so high, there’s no money left. Do we have topay capital gains tax?

The answers to these questions are at the end of this article.

OVERVIEW
In this article, I’ll review the possible ways divorcing couples can handle their house, and present the major considerations for and against each option. Then I’ll point out the capital gains tax rules, the tax rules for transfer of property between spouses, the tax rules for deductions related to houses. I’ve included Worksheets you can use to estimate what happens on sale and possible taxes.
Lastly I’ve selected part of the tax law and regulations if you want to dig more deeply yourself.

5 OPTIONS FOR A HOUSE

1. Sell it now.

2. Sell it later: one or both occupy until sale.

3. Transfer to other spouse, with or without cash payment, or trade, now or later.

4. Rent it to a third party and divide the income.

5. Transfer ownership to children or divorce mediator. Are there any other options?

Capital Gains tax and other considerations, drive decision.

MAJOR CONSIDERATIONS

Emotional attachment to house.

Children’s need for stability.

New significant other.

Financial ability to pay mortgage, taxes, insurance, and utilities.

Financial entanglement of existing joint mortgage, or future debts of one spouse, or future rental income.

Investment value of real estate.

Capital gains tax due on sale.

SELL IT NOW

NON-TAX REASONS TO SELL NOW:

Can’t afford to keep up mortgage and taxes.

Need cash now, non-user’s equity released.

Clean break.

Existing mortgage is paid off, no further problems of non-payment affecting both spouse’s credit, and no issue as to principal reduction.

Less need to agree on sales price as marketplace fixes actual price.

Agree on division of proceeds.

Avoids future non-cooperation of occupying spouse.

Nobody likes a house overlooking a cemetery.

NON-TAX REASONS NOT TO SELL NOW:

Cash not needed.

Less disruption for children.

Can’t agree on sales price, broker, etc.

No need to agree on future repairs and improvements.

Mortgage & taxes affordable.

TAX REASONS:

Right now, no tax is due on $500,000 of gain.

No need to agree on who gets tax deductions for interest and taxes.

SELL IT LATER

NON-TAX REASONS TO SELL LATER:

Custodial parent needs place to live with children.

Already separated.

Cash is not needed, non-user shares appreciation.

Agree on when to sell, and how to fix selling price and split, and possible option to buy by one spouse.

Agree on sharing of expenses: mortgage, taxes, insurance, repairs, dues, and selling expenses, and sharing of principal reduction.

NON-TAX REASONS NOT TO SELL IT LATER:

Can’t agree on sales price, broker, repairs and improvements, etc.

Usually a sharing of repair costs.

Non-user’s equity locked and non-producing.

Existing mortgage: non-payment affects both spouse’s credit.

Non-cooperation by occupying spouse on sale.

TAX REASONS:

Gain may still be exempt for both spouses.

Agree on who gets tax deduction for interest and taxes.

TRANSFER TO ONE SPOUSE

NON-TAX REASONS TO TRANSFER:

Clean Break.

Non-user equity no longer an issue.

Spouse owns where s/he lives, makes own decisions as to repairs and improvement.

Carrying is affordable.

Children need home.

No complications on sale, or

No need to agree on sales price, broker, repairs or improvements, etc.

Spouse wants new significant other to move in.

Agree on price and terms.

Principal reduction of mortgage belongs to owner.

House does not overlook bus garage.

NON-TAX REASONS NOT TO TRANSFER:

Unable to agree on price and terms.

Unable to pay the price by cash, trading assets, nor new mortgage.

Advantage of not moving for only one spouse.

Existing mortgage – how and when to refinance out of joint name.

TAX REASONS:

No tax due on transfer, but what happens to other spouse’s $250,000 exemption?

No need to agree on who gets tax deductions for interest and taxes.

THE BUILDING BLOCKS OF CAPITAL GAINS TAX

Capital Gains Definition: Profit on an asset.

Profit: the extra money from selling for more than you bought.

A little deeper: From selling price subtract:

Costs of sale (brokerage commission, fix up expenses, attorney fees); and

Costs of Improvement (new rooms, renovated kitchen, bathroom) but not repairs; and

Costs of Purchase; and

Original purchase price, or adjusted basis from previous rollover.

Add back:

Depreciation taken on previous tax return.

WHAT IS CAPITAL OR WHAT KIND OF PROPERTY IS TAXED?

Theory: any thing sold at a profit.

Real Life: Stocks, bonds, mutual funds.

Real estate, especially investment property

Collectibles: art, jewelry, stamps, coins, antique cars Hardly ever: stock cars, jewelry

Principal residence: because of $250,000 exemption per spouse.

SPECIAL RULES FOR PRINCIPAL RESIDENCE

$250,000 of gain excluded for each taxpayer if:

A. It’s a principal residence.

B. Owned for 2 of last 5 years

C. Occupied for 2 of last 5 years

D. No exclusion used in past 2 years.

Marital status is irrelevant.

Joint return:

E. Is doubling of 2 taxpayers;

F. only 1 needs to own;

G. but both must use;

H. neither used exclusion within 2 years.

$500,000 available on joint return or 2 individual returns.

Related sale of vacant land gets exclusion also.

If taxpayer has 2 residences, only 1 is eligible for exclusion: the most principal.

2 year use and ownership need not be concurrent.

Use requirement: not affected by vacations

Mixed use must be allocated

$250,000 may be reduced for lower time periods of use, ownership, or previous exclusion.

Taxpayer can elect not to exclude gain.

NO LOSSES
Loss on the sale of a personal residence is not deductible, because IRS does not consider it a loss on a transaction entered into for profit. But if taxpayer begins using a personal residence for business purposes and is using it for business purposes at the time of the sale, loss on its sale is allowable as a deduction.

MILITARY SUSPENSION
The Military Family Tax Relief Act of 2003 allows for the suspension of the five-year period during which these two-year use and occupancy requirements must be met. A person in the military (or in the foreign service) may elect to suspend these requirements for a maximum of 10 years, while serving at a duty station that is at least 50 miles from the taxpayer's principal residence, or while living in government quarters under government orders.

AVOIDING TAX

Virtually the only way to avoid tax on home sale gains exceeding the exemption is to use a "Starker" delayed tax-deferred exchange, as authorized by Internal revenue Code 1031 (a)(3). To qualify, before selling it will be necessary to move out of your principal residence and rent it to tenants. The tax law doesn't specify the minimum rental time. This would be an ideal situation to lease-option the home to a prospective buyer, but restrict exercise of the purchase option to perhaps six months after moving, thus showing the property has been converted to rental status before its sale. Then it can be sold as a rental property. You might wish to use the tax-deferred exchange sales proceeds to acquire an investment property or perhaps a residential rental property, which will eventually become your personal residence or a second home. However, the acquired property in a tax-deferred exchange must be a rental property at the time of acquisition. Most tax advisors suggest renting it at least six to 12 months (to show rental intent)before converting it to your personal residence by moving in.

SPECIAL, SPECIAL RULES

FOR DIVORCED SELLERS

2-Year Use requirement is waived for taxpayer if:

A. S/he is still an owner;

B. Spouse or former spouse has use pursuant to court order or separation agreement; and

C. Other spouse or former spouse uses property as principal residence.

TAX TRAP
If a spouse resides outside of the home, voluntarily, i.e. not pursuant to a divorce judgment or separation agreement for more than two years and the home is then sold, the excluded spouse is not eligible for the exclusion since it was not his/her principal residence for two years prior to the sale, and special rule B does not apply because there is no agreement and no court order.

PARTIAL EXEMPTION

A part of the $250,000 exemption is available for home sales within less than 24 months of ownership and occupancy if the reason for the sale is (a) change of employment location, (b) health reasons for illness treatment or to care for a family member, and c) unforeseen circumstances, which includes death,divorce, unemployment, change of employment leaving the taxpayer unable to pay the mortgage or basic living expenses, multiple births from the same pregnancy, damage to the residence, condemnation or involuntary conversion of the property. The partial exemptions is based on the percentage of the 24-month occupancy time. For example, if you occupied your principal residence for 18 of the required 24 months and sold due to one of the approved reasons, you then will be entitled to 75 percent of the $250,000 or $500,000 principal residence sale exemption.

SPECIAL RULES FOR TRANSFER OF PROPERTY

INCIDENT TO DIVORCE

A. When any capital property, including house, is transferred from one spouse to the other as part of a divorce, there is no tax due upon the transfer.

B. Capital gains tax is only due upon a later sale to a third party.

C. New owner owes tax based on original price of house (called "basis" in tax law).

D. New owner may include former spouse’s residency to meet rule requiring 2 years of use.

E. New owner cannot opt to treat transfer as taxable event.

F. This transfer must occur within 6 years of divorce to qualify for non-tax treatment.

WHO GETS TO DEDUCT

HOUSING COSTS

SALE NOW:

Deduction for real estate taxes and mortgage interest on the House, belongs to who ever made the payments.

If paid from joint account, either spouse can get deduction, but not both

TRANSFER TO ONE SPOUSE:

Only the spouse who owns the House can take the deductions.

Maintenance/alimony payments/deduction could be used to get tax breaks for both.

SALE LATER

If one spouse is obligated to pay the mortgage payments or property taxes on a residence, double considerations of mortgage interest and property tax deductions become relevant, with alimony as an umbrella concept.

Mortgage Interest & Property Taxes:

a) It is not unusual for one of the spouses to be required to make mortgage payments on the marital home even though he or she does not live in it. Mortgage interest must be paid with respect to a "qualified residence" to be deductible. The Code states that a "qualified residence" must be either the principal residence or "1 other residence of the taxpayer which is . . . used by the taxpayer as a residence..."

b) It is helpful that the taxpayer is deemed to have used a residence to the extent that s/he or "any member of the family of the taxpayer" uses it. So if the payor’s children live in the home, the requirement is probably satisfied. It is doubtful whether an ex-wife constitutes "any member of the family."

c) Even if the payment cannot be deducted as mortgage interest, it may be deductible as alimony.

d) Payments of mortgage principal are not deductible.

HOUSE SALE & CAPITAL GAINS TAX WORKSHEET

THE HOME

TOTAL

WIFE'S

SHARE

HUSBAND'S

SHARE

1.Estimated or Actual Selling Price

of this House:

2. Brokerage commission (usually

6%):

3. Closing Costs (usually 1%):

4. Amount realized for Capital

Gains Tax purposes (Line 1 minus Lines 2 and 3)

5. Mortgage Balance & any other

liens: (Not part of capital gain calculation)

6.Net cash before taxes

(Line 4 minus Line 5):

CAPITAL GAINS TAX

7. Original Price of this House:

orAdjusted Basis from previous rollover:

8. Improvements & Original

Closing Costs:

9. Depreciation deducted on

previous returns or other

decreases in basis:

10. Adjusted Basis of House Sold

(Line 7 plus Line 8 minus Line 9):

11. Capital Gain on Sale

(Line 4 minus Line 10):

12. Exclusion: $250,000 or

$500,000 on joint return

13.Taxable Gain

(Line 11 minus Line 12):

14.Capital Gains Tax:

(Multiply Line 13 by the Capital Gains Tax rate for your estimated tax bracket)

15. Net Cash After Taxes

(Line 6 minus Line 14):

Instructions for Capital Gains Tax Worksheet for Principal Residence

Line 1: Estimate a realistic sales price, or use the actual price if you have sold your house.

Line 2: This item is optional if there’s no actual sale contemplated. But some people still include it if they think a later sale is inevitable.

Line 3: Closing costs for a sale usually include attorney’s fees, transfer tax and little more. But they could include advertising, a survey, and mortgage points paid by the seller. This item is also optional if there’s no actual sale contemplated. But some people still include it if they think a later sale is inevitable.

Line 5: Mortgage amounts are not included in capital gains tax calculations.

Line 7: If this is the first house you’ve owned, put in the gross purchase price. If you’ve owned another house before this one, fill in the adjusted basis from the last sale. This figure is shown on Income Tax form 2119, which you should have filed for the year you purchased this house. If you don’t have the form, you may be able to get it from IRS. Otherwise, you can recalculate it yourself.

Line 8: Improvements are things that add to the permanent value of the house, such as additions, paving a driveway, a new roof, or an intercom system. Usually, maintenance and repairs of existing features do not count as improvements. Also include here the closing costs for buying this house.

Line 9: If your are no longer using this house as a home office or rental, and if you took any depreciation on this house, you put it back here. If you are still using the house for rental or home office, use the next form for that portion of the house.Other decreases are insurance reimbursements for casualty losses, payments for easements or rights of way, residential energy credits and energy conservation subsidies.

Line 11: If this is zero, or a "negative" number, there’s no Capital Gain, no tax, and no problem. Line 6 is your actual net.

Line 12: If you’re still married when the house is sold, you can exclude a total of $500,000. If you’re divorced before the house is sold, you can each exclude $250,000. In order to get this tax free treatment, you must have owned the house for five years, and used it as a principal residence for two of those five years. A spouse who takes title from the other may include the other spouse’s time of ownership in making up the five years of ownership needed to qualify. A spouse who moves, while remaining a joint owner, is allowed to include the other spouse’s time in the house for the two year use rule.

Line 13: If this is zero, or a "negative" number, there’s no Capital Gains tax, and no problem. Line 6 is your actual net.

HOUSE SALE & CAPITAL GAINS TAX WORKSHEET

$67,000 Gain

THE HOME

TOTAL

WIFE'S

SHARE

HUSBAND'S

SHARE

1.Estimated or Actual Selling Price

of this House:

$400,000.00

$200,000.00

200,000.00

2. Brokerage commission (usually

6%):

24,000.00

12,000.00

3. Closing Costs (usually 1%):

4,000.00

2,000.00

4. Amount realized for Capital

Gains Tax purposes (Line 1 minus Lines 2 and 3)

372,000.00

186,000.00

5. Mortgage Balance & any other

liens: (Not part of capital gain calculation)

250,000.00

125,000.00

6.Net cash before taxes

(Line 4 minus Line 5):

122,000.00

61,000.00

CAPITAL GAINS TAX

7. Original Price of this House:

orAdjusted Basis from previous rollover:

$300,000.00

8. Improvements & Original

Closing Costs:

$5,000.00

9. Depreciation deducted on

previous returns or other

decreases in basis:

$0.00

10. Adjusted Basis of House Sold

(Line 7 plus Line 8 minus Line 9):

$305,000.00

11. Capital Gain on Sale

(Line 4 minus Line 10):

$67,000.00

$33,500.00

12. Exclusion: $250,000 or

$500,000 on joint return

$250,000.00

$125,000.00

13.Taxable Gain

(Line 11 minus Line 12):

$0.00

14.Capital Gains Tax:

(Multiply Line 13 by the Capital Gains Tax rate for your estimated tax bracket)

$0.00

15. Net Cash After Taxes

(Line 6 minus Line 14):

122,000.00

61,000.00

HOUSE SALE & CAPITAL GAINS TAX WORKSHEET

$250,000 Gain

THE HOME

TOTAL

WIFE'S

SHARE

HUSBAND'S

SHARE

1.Estimated or Actual Selling Price

of this House:

$500,000.00

2. Brokerage commission (usually

6%):

30,000.00

3. Closing Costs (usually 1%):

5,000.00

4. Amount realized for Capital

Gains Tax purposes (Line 1 minus Lines 2 and 3)

465,000.00

5. Mortgage Balance & any other

liens: (Not part of capital gain calculation)

150,000.00

6.Net cash before taxes

(Line 4 minus Line 5):

315,000.00

CAPITAL GAINS TAX

7. Original Price of this House:

orAdjusted Basis from previous rollover:

$200,000.00

8. Improvements & Original

Closing Costs:

$15,000.00

9. Depreciation deducted on

previous returns or other

decreases in basis:

$0.00

10. Adjusted Basis of House Sold

(Line 7 plus Line 8 minus Line 9):

$215,000.00

11. Capital Gain on Sale

(Line 4 minus Line 10):

$250,000.00

12. Exclusion: $250,000 or

$500,000 on joint return

$250,000.00

13.Taxable Gain

(Line 11 minus Line 12):

$0.00

14.Capital Gains Tax:

(Multiply Line 13 by the Capital Gains Tax rate for your estimated tax bracket)

$0.00

15. Net Cash After Taxes

(Line 6 minus Line 14):

315,000.00

HOUSE SALE & CAPITAL GAINS TAX WORKSHEET

$500,000 Gain

THE HOME

TOTAL

WIFE'S

SHARE

HUSBAND'S

SHARE

1.Estimated or Actual Selling Price

of this House:

$800,000.00

$400,000.00

400,000.00

2. Brokerage commission (usually

6%):

48,000.00

24,000.00

3. Closing Costs (usually 1%):

8,000.00

4,000.00

4. Amount realized for Capital

Gains Tax purposes (Line 1 minus Lines 2 and 3)

744,000.00

372,000.00

5. Mortgage Balance & any other

liens: (Not part of capital gain calculation)

150,000.00

75,000.00

6.Net cash before taxes

(Line 4 minus Line 5):

594,000.00

297,000.00

CAPITAL GAINS TAX

7. Original Price of this House:

orAdjusted Basis from previous rollover:

$200,000.00

8. Improvements & Original

Closing Costs:

$44,000.00

9. Depreciation deducted on

previous returns or other

decreases in basis:

$0.00

10. Adjusted Basis of House Sold

(Line 7 plus Line 8 minus Line 9):

$244,000.00

11. Capital Gain on Sale

(Line 4 minus Line 10):

$500,000.00

$250,000.00

12. Exclusion: $250,000 or

$500,000 on joint return

$500,000.00

$250,000.00

13.Taxable Gain

(Line 11 minus Line 12):

$0.00

14.Capital Gains Tax:

(Multiply Line 13 by the Capital Gains Tax rate for your estimated tax bracket)

$0.00

15. Net Cash After Taxes

(Line 6 minus Line 14):

594,000.00

297,000.00

HOUSE SALE & CAPITAL GAINS TAX WORKSHEET

$685,000 Gain

THE HOME

TOTAL

WIFE'S

SHARE

HUSBAND'S

SHARE

1.Estimated or Actual Selling Price

of this House:

$999,000.00

$499,500.00

499,500.00

2. Brokerage commission (usually

6%):

59,940.00

29,970.00

3. Closing Costs (usually 1%):

9,990.00

4,995.00

4. Amount realized for Capital

Gains Tax purposes (Line 1 minus Lines 2 and 3)

929,070.00

464,535.00

5. Mortgage Balance & any other

liens: (Not part of capital gain calculation)

150,000.00

75,000.00

6.Net cash before taxes

(Line 4 minus Line 5):

779,070.00

389,535.00

CAPITAL GAINS TAX

7. Original Price of this House:

orAdjusted Basis from previous rollover:

$200,000.00

8. Improvements & Original

Closing Costs:

$44,000.00

9. Depreciation deducted on

previous returns or other

decreases in basis:

$0.00

10. Adjusted Basis of House Sold

(Line 7 plus Line 8 minus Line 9):

$244,000.00

11. Capital Gain on Sale

(Line 4 minus Line 10):

$685,070.00

$342,535.00

12. Exclusion: $250,000 or

$500,000 on joint return

$500,000.00

$250,000.00

13.Taxable Gain

(Line 11 minus Line 12):

$185,070.00

$92,535.00

14.Capital Gains Tax:

(Multiply Line 13 by the Tax rate for your tax bracket: 15% Federal & 8% NY State)

$42,566.10

$21,283.05

15. Net Cash After Taxes

(Line 6 minus Line 14):

736,503.90

368,251.95

HOUSE SALE & CAPITAL GAINS TAX WORKSHEET

$685,000 Gain

THE HOME

TOTAL

WIFE'S

SHARE

HUSBAND'S

SHARE

1. Estimated or Actual Selling Price

of this House:

$999,000.00

2. Brokerage commission (usually

6%):

59,940.00

3. Closing Costs (usually 1%):

9,990.00

4. Amount realized for Capital

Gains Tax purposes (Line 1 minus Lines 2 and 3)

929,070.00

5. Mortgage Balance & any other

liens: (Not part of capital gain calculation)

150,000.00

6. Net cash before taxes

(Line 4 minus Line 5):

779,070.00

CAPITAL GAINS TAX

7. Original Price of this House:

or Adjusted Basis from previous rollover:

$200,000.00

8. Improvements & Original

Closing Costs:

$44,000.00

9. Depreciation deducted on

previous returns or other

decreases in basis:

$0.00

10. Adjusted Basis of House Sold

(Line 7 plus Line 8 minus Line 9):

$244,000.00

11. Capital Gain on Sale

(Line 4 minus Line 10):

$685,070.00

12. Exclusion: $250,000 or

$500,000 on joint return

$250,000.00

13. Taxable Gain

(Line 11 minus Line 12):

$435,070.00

14. Capital Gains Tax:

(Multiply Line 13 by the Tax rate for your tax bracket: 15% Federal & 8% NY State)

$100,066.10

15. Net Cash After Taxes

(Line 6 minus Line 14):

679,003.90

IRS REGULATIONS

§ 1.121–1 Exclusion of gain from sale or exchange of a principal residence.

(a) In general. Section 121 provides that, under certain circumstances, gross income does not include gain realized on the sale or exchange of property that was owned and used by a taxpayer as the taxpayer’s principal residence. Subject to the other provisions of section 121, a taxpayer may exclude gain only if, during the 5-year period ending on the date of the sale or exchange, the taxpayer owned and used the property as the taxpayer’s principal residence for periods aggregating 2 years or more.

(b) Residence—

(1) In general.

Whether property is used by the taxpayer as the taxpayer’s residence depends upon all the facts and circumstances. A property used by the taxpayer as the taxpayer’s residence may include a houseboat, a house trailer, or the house or apartment that the taxpayer is entitled to occupy as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in section 216(b)(1) and (2)).

Property used by the taxpayer as the taxpayer’s residence does not include personal property that is not a fixture under local law.

(2) Principal residence.
In the case of a taxpayer using more than one property as a residence, whether property is used by the taxpayer as the taxpayer’s principal residence depends upon all the facts and circumstances. If a taxpayer alternates between 2 properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer’s principal residence. In addition to the taxpayer’s use of the property, relevant factors in determining a taxpayer’s principal residence, include, but are not limited to-

(I) The taxpayer’s place of employment; (ii) The principal place of abode of the taxpayer’s family members; (iii) The address listed on the taxpayer’s federal and state tax returns, driver’s license, automobile registration, and voter registration card; (iv) The taxpayer’s mailing address for bills and correspondence; (v) The location of the taxpayer’s banks; and (vi) The location of religious organizations and recreational clubs with which the taxpayer is affiliated.

(3) Vacant land—
(I) In general.
The sale or exchange of vacant land is not a sale or exchange of the taxpayer’s principal residence unless— (A) The vacant land is adjacent to land containing the dwelling unit of the taxpayer’s principal residence; (B) The taxpayer owned and used the vacant land as part of the taxpayer’s principal residence; (c) The taxpayer sells or exchanges the dwelling unit in a sale or exchange that meets the requirements of section 121 within 2 years before or 2 years after t he date of the sale or exchange of the vacant land; and (D) The requirements of section 121 have otherwise been met with respect to the vacant land.

(ii) Limitations— (A) Maximum limitation amount. For purposes of section 121(b)(1) and (2) (relating to the maximum limitation amount of the section 121 exclusion), the sale or exchange of the dwelling unit and the vacant land are treated as one sale or exchange. Therefore, only one maximum limitation amount of $250,000 ($500,000 for certain joint returns) applies to the combined sales or exchanges of vacant land and the dwelling unit. In applying the maximum limitation amount to sales or exchanges that occur in different taxable years, gain from the sale or exchange of the dwelling unit, up to the maximum limitation amount under section 121(b)(1) or (2), is excluded first and each spouse is treated as excluding onehalf of the gain from a sale or exchange to which section 121(b)(2)(A) and § 1.121–2(a)(3)(I) (relating to the limitation for certain joint returns) apply. (B) Sale or exchange of more than one principal residence in 2-year period. If a dwelling unit and vacant land are sold or exchanged in separate transactions that qualify for the section 121 exclusion under this paragraph (b)(3), each of the transactions is disregarded in applying section 121(b)(3) (restricting the application of section 121 to only 1 sale or exchange every 2 years) to the other transactions but is taken into account as a sale or exchange of a principal residence on the date of the transaction in applying section 121(b)(3) to that transaction and the sale or exchange of any other principal residence. (c) Sale or exchange of vacant land before dwelling unit. If the sale or exchange of the dwelling unit occurs in a later taxable year than the sale or exchange of the vacant land and after the date prescribed by law (including extensions) for the filing of the return for the taxable year of the sale or exchange of the vacant land, any gain from the sale or exchange of the vacant land must be treated as taxable on the taxpayer’s return for the taxable year of the sale or exchange of the vacant land. If the taxpayer has reported gain from the sale or exchange of the vacant land as taxable, after satisfying the requirements of this paragraph (b)(3) the taxpayer may claim the section 121 exclusion with regard to the sale or exchange of the vacant land (for any period for which the period of limitation under section 6511 has not expired) by filing an amended return. (4) Examples. The provisions of this paragraph (b) are illustrated by the
following examples: Example 1. Taxpayer A owns 2 residences, one in New York and one in Florida. From 1999 through 2004, he lives in the New York residence for 7 months and the Florida residence for 5 months of each year. In the absence of facts and circumstances indicating otherwise, the New York residence is A’s principal residence. A would be eligible for the section 121 exclusion of gain from the sale or exchange of the New York residence, but not the Florida residence. Example 2. Taxpayer B owns 2 residences, one in Virginia and one in Maine. During 1999 and 2000, she lives in the Virginia residence. During 2001 and 2002, she lives in the Maine residence. During 2003, she lives in the Virginia residence. B’s principal residence during 1999, 2000, and 2003 is the Virginia residence. B’s principal residence during 2001 and 2002 is the Maine residence. B would be eligible for the 121 exclusion of gain from the sale or exchange of either residence (but not both) during 2003. Example 3. In 1991 Taxpayer C buys property consisting of a house and 10 acres that she uses as her principal residence. In May 2005 C sells 8 acres of the land and realizes a gain of $110,000. C does not sell the dwelling unit before the due date for filing C’s 2005 return, therefore C is not eligible to exclude the $110,000 of gain. In March 2007 C sells the house and remaining 2 acres realizing a gain of $180,000 from the sale of the house. C may exclude the $180,000 of gain. Because the sale of the 8 acres occurred within 2 years from the date of the sale of the dwelling unit, the sale of the 8 acres is treated as a sale of the taxpayer’s principal residence under paragraph (b)(3) of this section. C may file an amended return for 2005 to claim an exclusion for $70,000 ($250,000–$180,000 gain previously excluded) of the $110,000 gain from the sale of the 8 acres. Example 4. In 1998 Taxpayer D buys a house and 1 acre that he uses as his principal residence. In 1999 D buys 29 acres adjacent to his house and uses the vacant land as part of his principal residence. In 2003 D sells the house and 1 acre and the 29 acres in 2 separate transactions. D sells the house and 1 acre at a loss of $25,000. D realizes $270,000 of gain from the sale of the 29 acres. D may exclude the $245,000 gain from the 2 sales. (c) Ownership and use requirements— (1) In general. The requirements of ownership and use for periods aggregating 2 years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 × 2). The requirements of ownership and use may be satisfied during nonconcurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale or exchange. (2) Use. (I) In establishing whether a taxpayer has satisfied the 2-year use requirement, occupancy of the residence is required. However, short temporary absences, such as for vacation or other seasonal absence (although accompanied with rental of the residence), are counted as periods of use. (ii) Determination of use during periods of out-of-residence care. If a taxpayer has become physically or mentally incapable of self-care and the taxpayer sells or exchanges property that the taxpayer owned and used as the taxpayer’s principal residence for periods aggregating at least 1 year during the 5-year period preceding the sale or exchange, the taxpayer is treated as using the property as the taxpayer’s principal residence for any period of time during the 5-year period in which the taxpayer owns the property and resides in any facility (including a nursing home) licensed by a State or political subdivision to care for an individual in the taxpayer’s condition. (3) Ownership— (I) Trusts. If a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121,
and the sale or exchange by the trust will be treated as if made by the taxpayer. (ii) Certain single owner entities. If a residence is owned by an eligible entity (within the meaning of § 301.7701–3(a) of this chapter) that has a single owner and is disregarded for federal tax purposes as an entity separate from its owner under § 301.7701–3 of this chapter, the owner will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the entity will be treated as if made by the owner. (4) Examples. The provisions of this paragraph ©) are illustrated by the following examples. The examples assume that § 1.121–3 (relating to the reduced maximum exclusion) does not apply to the sale of the property. The examples are as follows: Example 1. Taxpayer A has owned and used his house as his principal residence since 1986. On January 31, 1998, A moves to another state. A rents his house to tenants from that date until April 18, 2000, when he sells it. A is eligible for the section 121 exclusion because he has owned and used the house as his principal residence for at least 2 of the 5 years preceding the sale. Example 2. Taxpayer B owns and uses a house as her principal residence from 1986 to the end of 1997. On January 4, 1998, B moves to another state and ceases to use the house. B’s son moves into the house in March 1999 and uses the residence until it is sold on July 1, 2001. B may not exclude gain from the sale under section 121 because she did not use the property as her principal residence for at least 2 years out of the 5 years preceding the sale. Example 3. Taxpayer C lives in a townhouse that he rents from 1993 through 1996. On January 18, 1997, he purchases the townhouse. On February 1, 1998, C moves into his daughter’s home. On May 25, 2000, while still living in his daughter’s home, C sells his townhouse. The section 121 exclusion will apply to gain from the sale because C owned the townhouse for at least 2 years out of the 5 years preceding the sale (from January 19, 1997 until May 25, 2000) and he used the townhouse as his principal residence for at least 2 years during the 5- year period preceding the sale (from May 25, 1995 until February 1, 1998). Example 4. Taxpayer D, a college professor, purchases and moves into a house on May 1, 1997. He uses the house as his principal residence continuously until September 1, 1998, when he goes abroad for a 1-year sabbatical leave. On October 1, 1999, 1 month after returning from the leave, D sells the house. Because his leave is not considered to be a short temporary absence under paragraph (c)(2) of this section, the period of the sabbatical leave may not be included in determining whether D used the house for periods aggregating 2 years during the 5-year period ending on the date of the sale. Consequently, D is not entitled to exclude gain under section 121 because he did not use the residence for the requisite period. Example 5. Taxpayer E purchases a house on February 1, 1998, that he uses as his principal residence. During 1998 and 1999, E leaves his residence for a 2-month summer vacation. E sells the house on March 1, 2000. Although, in the 5-year period preceding the date of sale, the total time E used his residence is less than 2 years (21 months), the section 121 exclusion will apply to gain from the sale of the residence because, under paragraph (c)(2) of this section, the 2-month vacations are short temporary absences and are counted as periods of use in determining whether E used the residence for the requisite period. (d) Depreciation taken after May 6, 1997— (1) In general. The section 121 exclusion does not apply to so much of the gain from the sale or exchange of property as does not exceed the portion of the depreciation adjustments (as defined in section 1250(b)(3)) attributable to the property for periods after May 6, 1997. Depreciation adjustments allocable to any portion of the property to which the section 121 exclusion does not apply under paragraph (e) of this section are not taken into account for this purpose. (2) Example. The provisions of this paragraph (d) are illustrated by the
following example: Example. On July 1, 1999, Taxpayer A moves into a house that he owns and had rented to tenants since July 1, 1997. A took depreciation deductions totaling $14,000 for the period that he rented the property. After using the residence as his principal residence for 2 full years, A sells the property on August 1, 2001. A’s gain realized from the sale is $40,000. A has no other section 1231 or capital gains or losses for 2001. Only $26,000 ($40,000 gain realized—$14,000 depreciation deductions) may be excluded under section 121. Under section 121(d)(6) and paragraph (d)(1) of this section, A must recognize $14,000 of the gain as unrecaptured section 1250 gain within the meaning of section 1(h). (e) Property used in part as a principal residence— (1) Allocation required. Section 121 will not apply to the gain allocable to any portion (separate from the dwelling unit) of property sold or exchanged with respect to which a taxpayer does not satisfy the use requirement. Thus, if a portion of the property was used for residential purposes and a portion of the property (separate from the dwelling unit) was used for non-residential purposes, only the gain allocable to the residential portion is excludable under section 121. No allocation is required if both the residential and non-residential portions of the property are within the same dwelling unit. However, section 121 does not apply to the gain allocable to the residential portion of the property to the extent provided by paragraph (d) of this section. (2) Dwelling unit. For purposes of this paragraph (e), the term dwelling unit has the same meaning as in section 280A(f)(1), but does not include appurtenant structures or other property. (3) Method of allocation. For purposes of determining the amount of gain allocable to the residential and nonresidential portions of the property, the taxpayer must allocate the basis and the amount realized between the residential and the non-residential portions of the property using the same method of allocation that the taxpayer used to determine depreciation adjustments (as defined in section 1250(b)(3)), if applicable. (4) Examples. The provisions of this paragraph (e) are illustrated by the following examples: Example 1. Non-residential use of property not within the dwelling unit. (I) Taxpayer A owns a property that consists of a house, a stable and 35 acres. A uses the stable and 28 acres for non-residential purposes for more than 3 years during the 5-year period preceding the sale. A uses the entire house and the remaining 7 acres as his principal residence for at least 2 years during the 5- year period preceding the sale. For periods after May 6, 1997, A claims depreciation deductions of $9,000 for the non-residential use of the stable. A sells the entire property in 2004, realizing a gain of $24,000. A has no other section 1231 or capital gains or losses for 2004. (ii) Because the stable and the 28 acres used in the business are separate from the dwelling unit, the allocation rules under this paragraph (e) apply and A must allocate the basis and amount realized between the portion of the property that he used as his principal residence and the portion of the property that he used for non-residential purposes. A determines that $14,000 of the gain is allocable to the non-residential-use portion of the property and that $10,000 of the gain is allocable to the portion of the property used as his residence. A must recognize the $14,000 of gain allocable to the non-residential-use portion of the property ($9,000 of which is unrecaptured section 1250 gain within the meaning of section 1(h), and $5,000 of which is adjusted net capital gain). A may exclude $10,000 of the gain from the sale of the property. Example 2. Non-residential use of property not within the dwelling unit and rental of the entire property. (I) In 1998 Taxpayer B buys a property that includes a house, a barn, and 2 acres. B uses the house and 2 acres as her principal residence and the barn for an antiques business. In 2002, B moves out of the house and rents it to tenants. B sells the property in 2004, realizing a gain of $21,000. Between 1998 and 2004 B claims
depreciation deductions of $4,800 attributable to the antiques business. Between 2002 and 2004 B claims depreciation deductions of $3,000 attributable to the house. B has no other section 1231 or capital gains or losses for 2004. (ii) Because the portion of the property used in the antiques business is separate from the dwelling unit, the allocation rules under this paragraph (e) apply. B must allocate basis and amount realized between the portion of the property that she used as her principal residence and the portion of the property that she used for non-residential purposes. B determines that $4,000 of the gain is allocable to the non-residential portion of the property and that $17,000 of the gain is allocable to the portion of the property that she used as her principal residence. (iii) B must recognize the $4,000 of gain allocable to the non-residential portion of the property (all of which is unrecaptured section 1250 gain within the meaning of section 1(h)). In addition, the section 121 exclusion does not apply to the gain allocable to the residential portion of the property to the extent of the depreciation adjustments attributable to the residential portion of the property for periods after May 6, 1997 ($3,000). Therefore, B may exclude $14,000 of the gain from the sale of the property. Example 3. Non-residential use of a separate dwelling unit. (I) In 2002 Taxpayer C buys a 3-story townhouse and converts the basement level, which has a separate entrance, into a separate apartment by installing a kitchen and bathroom and removing the interior stairway that leads from the basement to the upper floors. After the conversion, the property constitutes 2 dwelling units within the meaning of paragraph (e)(2) of this section. C uses the first and second floors of the townhouse as his principal residence and rents the basement level to tenants from 2003 to 2007. C claims depreciation deductions of $2,000 for that period with respect to the basement apartment. C sells the entire property in 2007, realizing gain of $18,000. C has no other section 1231 or capital gains or losses for 2007. (ii) Because the basement apartment and the upper floors of the townhouse are separate dwelling units, C must allocate the gain between the portion of the property that he used as his principal residence and the portion of the property that he used for nonresidential purposes under paragraph (e) of this section. After allocating the basis and the amount realized between the residential and non-residential portions of the property, C determines that $6,000 of the gain is allocable to the non-residential portion of the property and that $12,000 of the gain is allocable to the portion of the property used as his residence. C must recognize the $6,000 of gain allocable to the non-residential portion of the pro