For many Americans one of their largest single assets is their principal residence. How income taxes affect a family’s principal residence is a very important consideration, so let’s look at some of these items and hopefully help make the tax questions easier. Here are the basics on the sale of a home:
Principal Residence
A taxpayer, either single, married filing joint (MFJ), or head of household (HH) can only have one principal residence per year; meaning, if you own multiple properties, only one can be your principal residence. Several factors determine your principal residence:
1. The amount of time spent at each residence. Where did you and/or your family live the most? A summer cottage does not count as a principal residence, unless you live there most of the time.
2. Place of employment. What is the proximity of the taxpayer's employment to the house that is being claimed as the principal residence? Is the other house closer?
3. Location of family members. Where do the family members live (spouse, children, other dependents, etc.)? Do they live in the house that is being claimed as the principal residence or the last claimed principal residence?
4. What address is listed on federal and state tax returns?
5. Auto and voter registration, are they consistent with the address for the principal residence?
6. The mailing address for bills and other correspondence. Are the pieces of mail delivered to the principal residence or some other place?
7. Where does the taxpayer do business with banks, churches, clubs, schools, cell towers showing phone activity, etc.?
These represent items the IRS would inquire about if a taxpayer was to claim a home different than their past home as their principal residence, particularly when it comes to the sale of the property and in claiming a section 121 exemption for capital gains tax.
Section 121 Exclusion
The section 121 exclusion allows for a taxpayer to exclude up to $250,000 for single or HH and $500,000 for MFJ of capital gains on the sale of a principal residence. This can be a significant amount of money for some taxpayers, who are near retirement and want to downsize, or others who need to move to a new home for any of several reasons.
As with most IRS regulations there is an ownership and occupancy test to make sure the taxpayer is entitled to the exclusion, here is the test for Section 121:
1. The taxpayer needs to have owned the house for at least two years during the five-year period before the house is sold. For a married couple, only one spouse has to meet the ownership test.
2. Occupancy test. The taxpayer must actually live in the residence; simply moving furniture in does not count. You can have short, temporary absences including vacations up to two months. A year-long sabbatical, for example, is not a temporary absence. However, if the home was destroyed or condemned, time in the home may count towards the ownership and occupancy. For married couples, both must have lived in the house for two years.
If a taxpayer did not use the exemption in the previous two years, they can take the section 121 exclusion. There are exceptions to the tests for deployed military personnel, senior foreign service personnel, etc. Under certain circumstances a partial exclusion maybe applied for.
There are other details that may or may not affect your particular situation, this was meant to be a basic explanation of how the sale of a principal residence would affect a taxpayer. If you have any questions give us a call and we will do our best to sort out the issue to get you the correct answers.
Photo by Todd Kent
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