Involuntary conversion of a principal residence.

• Author: Campbell, Alan D.

Natural disasters such as hurricanes, tornadoes, and wildfires destroy many homes. Accidental fires destroy additional homes each year. Individuals may also lose their homes to condemnation by a governmental body under the power of eminent domain. The homeowner often receives payment from an insurance company when a casualty destroys a principal residence or compensation from a governmental body for a condemned home. Receiving payment for a principal residence destroyed by a casualty or condemned by a governmental body is an involuntary conversion. Tax professionals should understand the tax consequences of an involuntary conversion of a taxpayer's principal residence to be able to advise their clients properly.

Homeowners may be able to use two provisions to avoid or defer paying tax on all or part of a gain realized on the involuntary conversion of a principal residence. Under Sec. 121, a taxpayer may exclude a certain amount of gain on the sale or exchange of a principal residence if the taxpayer meets the ownership and use tests. (1) Under Sec. 1033, on an involuntary conversion of a principal residence, the taxpayer may be able to defer any gain realized by replacing it with a different home within a specified time. (2) This article explains both provisions and describes the conditions under which a taxpayer may use the gain deferral provision of Sec. 1033, as well as its interplay with the Sec. 121 exclusion. Lastly, this article explains the rules regarding a casualty loss on a principal residence.

Sec. 121 exclusion

In general, a taxpayer must include all realized gains in gross income. (3) One commonly used exception allows individuals to exclude a gain of up to $250,000 ($500,000 if married filing a joint return) from their gross income on the sale or exchange of their principal residence. (4) Any remaining gain would be a long-term capital gain. (5) If the taxpayer excludes gain under Sec. 121, the taxpayer does not adjust the basis of any new home acquired due to the exclusion. To use the exclusion, the taxpayer must have owned the home and used it as a principal residence for a period of, or periods totaling, two years or more within the five years before the sale or exchange. (6) The periods of ownership and use do not have to be concurrent. (7)

If the ownership and use tests are not met, the taxpayer may qualify for a reduced maximum exclusion in certain circumstances. (8) The circumstances outlined in Sec. 121 include a sale by reason of a change in employment or health or due to unforeseen circumstances. (9) An involuntary conversion is one of a number of unforeseeable events that allow for a reduced maximum exclusion. (10) The reduced maximum exclusion equals $250,000 ($500,000 on a joint return) multiplied by the number of months (or days) of ownership and usage as a principal residence divided by 24 months (or 730 days). Example 1 illustrates the calculation of the reduced maximum exclusion.

Example 1: A, a single individual, owned and lived in a residence for six months until its destruction on Dec. 1 by flood. The maximum exclusion under Sec. 121 would be $62,500 ([6 / 24] x $250,000). Or, in terms of days of a continuous period beginning on June 1: (183 / 730) x $250,000 = $62,671. Home owned jointly by unmarried individuals

If two unmarried individuals own a home jointly and each individual uses it as a principal residence, then each owner may exclude up to $250,000 of realized gain if each owner meets all other requirements. (11) Example 2 illustrates an involuntary conversion of a principal residence owned by two unmarried individuals.

Example 2: B and C are brothers. Neither is married. They bought a home 20 years ago as tenants in common for $130,000 ($100,000 for the home and $30,000 for the land). B and C have used the home exclusively as their principal residence. During the current year, a tornado completely destroyed their home. The home had appreciated in value. They received $400,000 from an insurance company for the destruction of their home. They plan to build a new home on the same land. They realized a gain of $300,000 ($400,000 - $100,000), or $150,000 each, on the involuntary conversion of their home. They meet the ownership and use tests. Each of them may exclude the $150,000 gain from his gross income. Houseboats, house trailers, and apartments

A houseboat or house trailer, or an apartment the taxpayer is allowed to occupy as a tenant and stockholder in a cooperative housing corporation, may qualify as a principal residence. The exclusion does not apply to any gain realized on any personal property in the residence unless the personal property is a fixture under local law. (12) The exclusion does not apply to vacation homes, and the exclusion is not available to certain expatriates. (13)

Two or more homes

If a taxpayer owns two or more homes, determining which one is the principal residence depends on all the facts and circumstances. The home where the taxpayer spends the most time is generally the principal residence. Other factors to consider include the taxpayer's place of employment, the principal home where family members live, the address shown on tax returns and other government documents, the taxpayer's mailing address for bills, the location of the taxpayer's banks, and the location of religious organizations and recreational clubs with which the taxpayer is affiliated. (14)

Joint return

On a joint return, the $500,000 exclusion applies if (1) either spouse has owned the home for at least two of the previous five years before its sale; (2) both spouses have used the home as a principal residence for at least two of the five years before its sale; and (3) neither spouse has used the exclusion for a home sold within two years of the date of the sale of the current home. (15)

If the couple file a joint return and do not meet all of these requirements, then the requirements apply to each spouse as though the spouse were a single individual, for this purpose only. However, the law deems both spouses to have owned the home during the period that either of them owned it. (16)

Short, temporary absences

Short, temporary absences do not reduce the time the taxpayer has used the home as a principal residence. (17) A taxpayer may rent the home to a tenant during a short, temporary absence without reducing the time the law considers the taxpayer to have occupied the home. A one-year absence to work elsewhere, such as that of a college professor on a sabbatical, is not a short, temporary absence. (18) Leaving the home for a two-month vacation every year is a short, temporary absence. The law considers such vacations as periods of use of the home as a principal residence. (19)

The regulations do not address any period of absence longer than two months and shorter than one year. However, for the purpose of deducting travel expenses while away from a taxpayer's tax home temporarily, the law treats any period up to one year as being away from home overnight on a temporary basis. (20) While being away from the home for up to one year might be a temporary absence, that does not also mean that it is a short absence.

A vacation or seasonal absence is a short, temporary absence. (21) A season lasts for about three months, therefore any absence longer than three months may run a serious risk of the IRS's not treating it as a short, temporary absence.

Surviving spouse

If a surviving spouse sells a property within two years from the date of death of the deceased spouse, the law increases the $250,000 exclusion to $500,000, so long as the following conditions apply:

* Immediately before the date of death, either spouse owned the home for at least two of the previous five years before death;

* Both spouses used tne home as a principal residence for at least two of the five years before death;

* Neither spouse had used the exclusion for a home sold within two years prior to the date of death; (22) and

* The surviving spouse must not be remarried at the time of the sale. (23)

Grantor trusts and LLCs

If a grantor trust owns a home, the law deems the grantor to be the owner of the home for purposes of the Sec. 121 exclusion. If a grantor trust owns a home and an individual (or married couple) is either the owner of the trust or the owner of the part of the trust that includes the home, the grantor is the owner of the residence for purposes of the ownership test. Therefore, the law considers the involuntary conversion of the residence while such a grantor trust owns it as a sale by the taxpayer. (24)

If a limited liability company (LLC) with only one member and taxed as a disregarded entity owns the residence, it can qualify as the LLC member's principal residence for purposes of the ownership test. The law also treats such a residence as sold by the taxpayer upon its involuntary conversion. (25)

Out-of-residence care

A taxpayer who owns a home might become incapable of...