The IRS considers almost everything an individual owns and uses for personal or investment purposes, including real property, stocks and bonds in an investment portfolio and other possessions, a capital asset. When a capital asset is sold, the difference between the amount paid for the asset and the amount received as a result of the sale is a capital gain or a capital loss. Capital gains are generally included in a taxpayer’s taxable income.
Under Section 121, a single taxpayer may exclude from gross income up to a $250,000 gain from the sale or exchange of his or her principal residence as long as he or she meets the following conditions:
He or she has owned the property for at least two of the five years prior to the sale or exchange;
He or she has used the property as a principal residence for at least two of the five years prior to the sale or exchange; and
He or she has not sold another principal residence and taken the exclusion within the two years prior to the sale or exchange.
If taxpayers jointly own a principal residence but file separate returns, each taxpayer may exclude from gross income up to S250,000 of gain attributable to each taxpayer’s interest in the property, as long as the requirements of Section 121 have otherwise been met.
A husband and wife who file a joint return for the year of the sale or exchange may exclude up to S500,000 of gain if all of the following apply:
Either spouse meets the twoyear ownership requirement,
Both spouses meet the twoyear use requirement;
Neither spouse excluded gain from a prior sale or exchange of property under Section 121 within the last two years.
If the spouses fail to meet all three of these requirements, the maximum limitation amount to be claimed by the couple is the sum of each spouse’s $250,000 limitation amount determined on a separate basis as if they had not been married. For this purpose, each spouse is treated as owning the property during the period that either spouse owned the property.
Ownership and Use Qualifications
The requirements of ownership and use for periods aggregating two years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 days x 2). The two years do not have to be consecu
tive, so ownership and use requirements may be satisfied during non concurrent periods as long as both the ownership and use tests are met during the fiveyear period ending on the date of the sale or exchange. In establishing whether a taxpayer has satisfied the two-year use requirement, occupancy of the residence is required. Short temporary absences, such as vacations or other scasonal absences, even if accompanied with rental of the residence, are counted as periods of USC.
If a taxpayer obtains property from a spouse or former spouse in a divorce, the period during which the taxpayer is considered to have owned the property includes the period that the spouse or former spouse owned the property. A taxpayer is treated as using property as a principal residence for any period that the taxpayer has an ownership interest in the property. The taxpayer’s spouse or former spouse is granted use of the property under a divorce or separation instrument provided that the spouse or former spouse uses the property as a principal residence.
Safe Harbors and Unforeseen Circumstances Taxpayers who fail to qualify for the principal residence exemption may still qualify for a reduced maximum exclusion if the primary reason for the sale or exchange of a principal residence meets the criteria for one of several safe harbors. Safe harbor events include health issues, employment relocation and unforeseen circumstances. An unforeseen circumstance is defined as an event that a taxpayer could not reasonably have anticipated before purchasing and occupying the residence and may include death, divorce, multiple births from the same pregnancy, unemployment, natural disasters and acts of terrorism.
Other events or situations may be designated unforeseen circumstances by the IRS in published guidance of general applicability, or the LRS may issue individual rulings addressing specific situations. Factors that may be relevant in determining a taxpayer’s primary reason for a sale include, but are not limited to, the extent to which:
The sale and the circumstances giving rise to the sale are proximate in time;
The suitability of the property as the taxpayer’s principal residence materially changes;
The taxpayer’s financial ability to maintain the property is materially impaired;
The taxpayer uses the property as his or her residence during the period of ownership of the property;
The circumstances giving rise to the sale are not reasonably foresceable when the taxpayer begins using the property as his or her principal residence;
The circumstances giving rise to the sale occur during the period of the taxpayer’s owner ship and use of the property as the taxpayer’s principal resi dence;
The reduced maximum exclusion is computed by multiplying the maximum dollar limitation of S250,000 ($500,000 for certain joint filers) by a fraction. The numerator of the fraction is the shortest of the following periods:
The period of time that the taxpayer owned the property during the five-year period ending on the date of the sale of exchange;
The period of time that the taxpayer used the property as his or her principal residence during the five-year period ending on the date of the sale or exchange; or
The period of time between the date of a prior sale or ex change of property for which
the taxpayer excluded gain under Section 121 and the date of the current sale or exchange
The numerator of the fraction may be expressed in days or months. The denominator of the fraction is 730 days or 24 months, depending upon the measure of time used in the numerator.
Death of a Spouse
The sale of a residence that had been jointly owned and occupied by a surviving and a deceased spouse qualifies for the S500,000 gain exclusion, provided the sale occurs no later than two years after the decedent’s date of death. The surviving spouse in the case of a jointly owned residence continues to be allowed a step-up in basis in the residence for the deceased spouse’s one-half share. The S500,000 exclusion for surviving spouses is in addition to that benefit.