Capital Gain Exclusion on Sale of Principal Residence Formerly Held for Investment Purposes Raises Complex Issues

Capital Gains ExclusionEach person may exclude from income up to $250,000 of capital gain on the sale of the person’s principal residence (known as the “gain exclusion,” governed by Internal Revenue Code § 121). A married couple may exclude up to $500,000 if the following criteria are met: (a) the couple files their income tax returns as married filing jointly, (b) either spouse meets the ownership requirement, (c) both spouses meet the use requirement, and (d) neither spouse is ineligible under the frequency limit, which means that a taxpayer may only take advantage of the gain exclusion every two years. The ownership and use requirements are discussed below.

The taxpayer must have owned the residence during periods aggregating at least 2 years over the 5 years preceding the sale (the “ownership requirement”). The taxpayer must have used the property as his or her “principal residence” for periods aggregating at least 2 years over the 5 years preceding the sale (the “use requirement”). “Principal residence” generally means the residence the taxpayer occupies at least a majority of the time during the year, though other factors can be taken into consideration, such as the taxpayer’s mailing address and address used on tax returns, driver’s license, etc.

However, the gain exclusion does not apply to a proportionate amount of the gain attributable to periods of “nonqualified use.” A period of nonqualified use is defined as any period after January 1, 2009 during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse. The proportion of the gain for which the gain exclusion is not available is the ratio which the aggregate periods of nonqualified use bear to the total period the property was owned by the taxpayer. Periods of nonqualified use prior to January 1, 2009 are not counted against the taxpayer.

Examples of the nonqualified use calculation are as follows. Please note that these examples do not take into account depreciation, and assume that the taxpayer has not used the gain exclusion in the last two years (the frequency limit):

  1. A and B, a married couple, purchased a house prior to January 1, 2009 and rented it out from the time of purchase through December 31, 2012. A and B moved back into the house on January 1, 2013, and sold the house on January 1, 2015. Their gain on the sale was $225,000. Two-thirds of the gain (four years of rental use divided by six total years), or $150,000, is allocated to nonqualified use and is not eligible for the gain exclusion. The couple must treat the $150,000 as capital gain. However, the remaining $75,000 is less than the $500,000 maximum gain exclusion for a married couple filing jointly, so that the remaining gain is excluded from gross income.
  2. Assume the same facts as above, except the gain on the sale was $600,000. Two-thirds of the gain ($400,000) is allocated to nonqualified use and is not eligible for the gain exclusion. The couple must treat that amount as capital gain. The remaining $200,000 is less than the $500,000 maximum gain exclusion for a married couple filing jointly, so that $200,000 is excluded from gross income.
  3. Assume the same facts as above, except the gain on the sale was $1,800,000. Two-thirds of the gain ($1,200,000) is allocated to nonqualified use and is not eligible for the gain exclusion. The couple must treat that amount as capital gain. The remaining $600,000 exceeds the $500,000 maximum gain exclusion for a married couple filing jointly. The couple can exclude $500,000 from gross income, but must include a total of $1,300,000 ($1,200,000 for nonqualified use plus $100,000 in excess of the gain exclusion) as capital gains.

When a taxpayer purchases property and lives there as the taxpayer’s primary residence, but then moves out and converts the property to a nonqualified use, the taxpayer can still take the full amount of the gain exclusion so long as the homeowner still qualifies for the gain exclusion in all other respects. In other words, a primary residence that is subsequently converted to investment property will still qualify for the maximum available gain exclusion provided the property is sold no later than 3 years after its conversion to investment property. The property will no longer qualify for the gain exclusion once it has been held by the taxpayer as investment property beyond the three (3) year window. So, if the taxpayer converts a principal residence to an investment property, there is no pro-ration of the gain within the three (3) year window; if the taxpayer converts an investment property to a principal residence, pro-ration of the gain exclusion is required, as described above.

Exceptions to the above requirements may be available in certain situations, such as a sale of a residence due to a change in employment, health or unforeseen circumstances. Whether an exception applies is based on the particular facts and circumstances.

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