Savvy real estate buyers crowd path to tax-free profits

Using home-sale exemption to its full potential
By Robert J. Bruss: Inman News
Internal Revenue Code 121, the principal-residence-sale tax exemption, can be used over and over again, without limit, but not more frequently than once every 24 months. Some savvy home buyers have even created a tax-free business by buying a fixer-upper house, living in it at least 24 months, meanwhile renovating it to increase its market value.

If you do this over and over, you will soon become known as a tax-free "serial home seller!" A single person can qualify for up to $250,000 tax-free profits, but a married couple (or two qualified, unmarried co-owner residents) can qualify for up to $500,000 tax-exempt profits every 24 months. The big drawback, however, is living in the home while it is being renovated!

TESTS FOR DETERMINING YOUR PRINCIPAL RESIDENCE. Your IRC 121 primary or principal residence (the IRS calls it your "main home") is not always clear-cut, especially if you own two (or more) homes where you divided your occupancy time.

IRS regulations say your principal residence is "the property that the taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayer's principal residence." Short absences, such as for a vacation, count as occupancy time, such as spending two months in Europe. But a one-year absence from your home won't count as occupancy time (unless you meet the medical care exception explained earlier).

The latest IRS regulations also say: "In addition to the taxpayer's use of the property, relevant facts in determining a taxpayer's principal residence include, but are not limited to the: (1) taxpayer's place of employment; (2) principal place of abode of the taxpayer's family members; (3) address listed on the taxpayer's federal and state income tax returns and driver's license, automobile registration, and voter registration card; (4) location of the taxpayer's banks; and (5) location of religious organizations and recreational clubs with which the taxpayer is affiliated."

A major drawback of these IRS regulations is they might indicate a taxpayer's principal residence is at one home, but the taxpayer spends the majority of time at the other home.

EXAMPLE: Suppose a retired couple spends seven months of each year in their Minnesota condo and five months at their Florida home. The Minnesota home looks like their principal residence based on the majority of time test. However, if the couple files their income tax returns from Florida (which has no state income tax), vote in Florida, have a Florida homestead exemption, have their auto and driver's licenses in Florida, and have their bank accounts with a Florida bank, now it looks like the Florida residence is their principal residence. Based on the minimum 24-month occupancy test within the last five years before sale, either home meets that test.

PRINCIPAL RESIDENCE SALE EXEMPTION CAN INCLUDE PROFIT FROM THE SALE OF AN ADJOINING VACANT LOT. If you separately sell a vacant lot next to your principal residence, and if you sell it within two years before or after selling your principal residence, the lot sale capital gain can be included with the home-sale tax exemption. Of course, if you sell the lot to the buyer of your principal residence, the lot sale profit also clearly qualifies for the exemption.

However, this lot sale exemption only includes a "reasonable amount" of land adjoining your primary residence. This tax exemption cannot be used, for example, to make a tax-free farm sale just because the farm adjoins your home. Only the market value of the residence plus a reasonable amount of adjoining land can qualify.

NO ALLOCATION OF BASIS IS REQUIRED FOR HOME BUSINESS USE UNLESS THAT BUSINESS OPERATES FROM A SEPARATE BUILDING. If you operate a home business from your residence, when selling that property it used to be necessary to, in essence, make two sales – one of your principal residence and the other of your "business area." Fortunately, that is no longer necessary.

Tax advisers used to even suggest that you not claim any home business tax deductions for at least two years before selling your home – again, that is no longer necessary unless your home business is operated from a separate building on your residence property. Then an allocation to the value of the business building is required.

However, home sellers who claimed depreciation deductions for the business area of their residence after May 6, 1997, (the effective date of IRC 121) will have that depreciation "recaptured" (that means taxed!) upon home sale at a special 25 percent federal depreciation recapture tax rate. Home business depreciation deducted before that date is not recaptured and is taxed as long-term capital gain, subject to the $250,000 or $500,000 exemption.

IF YOU OWNED AND/OR OCCUPIED YOUR PRINCIPAL RESIDENCE LESS THAN 24 MONTHS WITHIN THE FIVE YEARS BEFORE ITS SALE, YOU MAY BE ENTITLED TO A PARTIAL $250,000 OR $500,000 EXEMPTION. Internal Revenue Code 121 pas passed by Congress in 1997 included three provisions for partial use of the $250,000/$500,000 exemptions: (1) change of employment location qualifying for the moving expense deduction, (2) health reasons, and (3) unforeseen circumstances. Those first two exceptions didn't cause much confusion. But the third exception, even after clarifying the new IRS regulations, still causes confusion. Let's take a look at each exception:

Change of employment location. If the home seller qualifies for the moving expense tax deduction, then that seller can also qualify for a partial IRC 121 exemption if the principal residence was owned and/or occupied less than the required 24 months during the five years before the home sale. Briefly, the moving expense deduction requires the taxpayer's new work location to be at least 50 miles further from the old principal residence than was the old work site.

EXAMPLE: Suppose your old principal residence was four miles from your old job location. You then changed job locations (whether with the same employer, a new employer, or you became self-employed doesn't matter). To qualify for the residential moving cost tax deduction, you new job location must be at least 50 miles further from your old home than was your old job site. In this example, that means your new work location would have to be at least 54 miles (4 + 50) to qualify. If you meet this test, you then also can claim the partial home-sale tax exemption.


The moving cost tax deduction also has work time tests, such as remaining employed at least 39 weeks during the year after the move in the vicinity of the new job location. For self-employed individuals, the minimum qualifying work time test is 78 weeks during the 104 weeks after the job location change. Either spouse can qualify, but "tacking" work time of one spouse unto another spouse's work time is not allowed.

Health reasons. Just because you think you will feel better living in Arizona rather than Alaska is not a sufficient health reason for selling your Alaska home and claiming a partial IRC 121 tax exemption! Qualified health reasons must usually be based on a physician's recommendation to the homeowner or a family member.

Health purposes can include (1) to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, and (2) need to move to care for a family member. But a home sale that is merely beneficial to the general health or well being of the individual does not qualify for the partial exemption.

Unforeseen circumstances. IRS regulations now include several "safe harbor" principal residence sale reasons, which the IRS will not challenge. The first five reasons must involve the taxpayer, spouse, co-owner, or member of the taxpayer's household. In addition, the IRS Commissioner has authority to approve a partial exemption for other unforeseen circumstances. The "safe harbor" unforeseen circumstances are:

(1) Death in the immediate family; (2) divorce or legal separation; (3) becoming eligible for unemployment compensation; (4) change in employment leaving the taxpayer unable to pay the mortgage or reasonable basic living expenses; (5) multiple births resulting from the same pregnancy; (6) damage to the residence from a natural or man-made disaster, or an act of war or terrorism; and (7) condemnation, seizure or other involuntary conversion of the property.

If you qualify, calculate the partial IRC 121 $250,000 or $500,000 percentage exemption based on your number of months of occupancy. If you qualify for a partial exemption, as explained above, it's easy to calculate your percentage exemption. The denominator of the fraction will always be 24 (months). The numerator will be the number of months you occupied your principal residence before moving out for one of the above reasons.

EXAMPLE: Suppose you owned and lived in your principal residence for 16 months before receiving a job location transfer notice from your employer, which qualifies for the moving-expense tax deduction. Your fraction will be 16/24 or two-thirds, which is 66.7 percent of the $250,000 or $500,000 exemption for which you are otherwise qualified. In this example, you therefore can claim up to $166,750 or $333,500 tax-free, home-sale profit, depending on whether you are single or married, meeting the partial-occupancy time test.