Maximizing gain exclusion/deferral when selling a principal residence due to death, divorce or marriage.

• Author: Pickett, Hilari D.

Is a client about to sell a home due to a death, divorce or marriage? The thicket of rules regarding Sec. 1034 gain deferral and Sec. 121 one" time gain exclusion are complex and require careful scrutiny. This article examines a number of presale planning techniques available in determining which election(s) should be made to maximize gain exclusion and/or deferral.

Society has experienced dramatic changes over the past several decades. For example, in 1970, only 6.2% of women and 9.4% of men in the U.S. were single at age 30; by 1994, those numbers had risen to 18.8% and 29.4%, respectively.(1) The 1994 divorce rate was more than double the 1960 rate.(2) Between 1960 and 1994, the average person's life expectancy increased by approximately six years, from 67 years to 73 years for men and from 73 years to 79 years for women.(3) Thus, it can be concluded that increasing numbers of home owners are single and many home owners marry more than once during their lifetime.

These societal changes bring important tax implications. Marriage, remarriage, death or divorce can complicate the application of the tax law when a home is sold and/or another is purchased. This article addresses the issues stemming from the purchase, sale or rental of a taxpayer's principal residence because of death, divorce or (re)marriage.

Defining "Principal Residence"

The Code does not precisely define "principal residence"; instead, the qualification of a residence as a principal residence depends on the facts and circumstances.(4) If a taxpayer owns several personal residences, only one may qualify as his principal residence(5); generally, this is the residence the taxpayer occupies a majority of the time.(6) Regs. Sec. 1.1034-1 (c)(3)(i) lists numerous types of property other than houses that have qualified as personal residences, including houseboats, trailers and stock held by a tenant-stockholder in a cooperative housing corporation; condominiums also qualify.(7) A principal residence need not be located in the U.S. to qualify.(8)

In some cases, it may be difficult finding a suitable replacement residence. If the taxpayer sells his principal residence and moves into rental property, the rental property becomes the new principal residence. When a new home is subsequently purchased, the taxpayer must vacate the rental property and actually reside in the new home for it to qualify as his principal residence.(9) If the taxpayer is unable to sell the old principal residence before occupying the new one, the old residence may be rented out temporarily without causing it to lose its status as a principal residence(10); further, the taxpayer may deduct rental expenses incurred without disqualifying the property.(11) However, if the taxpayer rented the residence for an extended period, a court might determine that it was no longer a former principal residence.(12)

Because the determination of a principal residence depends on the facts and circumstances, taxpayers should not automatically assume that their home qualifies as a principal residence for Secs. 1034 and 121 purposes.

Sec. 1034 Gain Rollover

Depending on the cost of the replacement residence, Sec. 1034 requires a taxpayer to defer all or a portion of the gain on the sale of a principal residence. For this purpose, Regs. Sec. 1.1034-1(b)(8) defines "sale" to include a cash transaction or an exchange; Regs. Sec. 1.1034-1(h) adds the replacement of a principal residence due to a condemnation or other involuntary conversion if the taxpayer does not elect to defer the gain under Sec. 1033.

To qualify for gain deferral, Sec. 1034(a) requires the taxpayer to acquire and occupy a new principal residence within the period beginning two years before and ending two years after the date of the sale of the old residence. According to Sec. 1034(h) and (k), this four-year replacement period is extended only for (1) certain members of the U.S. Armed Forces and (2) taxpayers who reside outside of the U.S. A taxpayer can fail the replacement period requirement even if circumstances beyond his control prevent occupancy of the new residence within the requisite period.(13)

Under Sec. 1034(c)(4) and (d), a taxpayer who sells two or more principal residences within a two-year period must calculate the gain deferral on the sale of the first residence by treating the last residence purchased during that period as the replacement residence; thus, gain on the sale of any intermediate residence must be recognized. Gain on the sale of intermediate residences may be deferred if the purchases are necessitated by business reasons and the taxpayer meets the Sec. 217(c) time and distance requirements.

If the taxpayer uses a residence partly as his principal residence and partly for other purposes (e.g., as a home office), only the gain allocable to the portion used as a principal residence may be deferred, according to Regs. Sec. 1.1034-1 (c)(3)(ii). Any gain allocable to the portion of the residence used for nonresidential or business purposes must be recognized under Sec. 1231.

Under Sec. 1034(a), a taxpayer recognizes gain only to the extent the adjusted sales price of the old residence exceeds the cost of the new one. There are three key elements in computing the gain to be recognized: (1) gain realized, (2) adjusted sales price and (3) cost of purchasing the new residence.

Gain Realized

According to Regs. Sec. 1.1034-1(b)(5), "gain realized" is the excess of the amount realized over the adjusted basis of the old residence. Regs. Sec. 1.1034-1(b)(4) defines "amount realized" as the selling price (including money received, the fair market value (FMV) of any property received and the amount of liability assumed by the buyer) less selling expenses. For this purpose, "selling expenses" include commissions, advertising expenses, costs of preparing a deed and other legal expenses incurred in connection with the sale.

Under Secs. 1012, 1016 and 1034(e), the adjusted basis of the old residence is the sum of the original purchase price and the cost of any subsequent capital improvements, less any gain previously deferred under Sec. 1034. If a portion of the home has been used for business purposes, the basis must be partitioned between the nonbusiness and business uses; depreciation taken or allowed on the business portion will decrease the business basis. This formula also applies in determining the taxpayer's adjusted basis in the new residence.

Adjusted Sales Price

The adjusted sales price is defined by Regs. Sec. 1.1034-1 (b)(3) as the amount realized, reduced by fixing-up expenses. The amount realized for purposes of the adjusted sales price is the same amount used in determining the gain realized. Fixing-up expenses are defined by Regs. Sec. 1.1034-1(b) as expenses incurred to assist in the sale of the old residence; such expenses must be incurred within the 90-day period ending on the day on which the contract to sell the old residence is entered into and be paid within 30 days of the sale.

Cost of the Replacement Residence

Regs. Sec. 1.1034-1(b)(7) defines "cost of purchasing a new residence" to include all amounts attributable to the acquisition, construction, reconstruction, and capital improvements made during the replacement period. According to Regs. Sec. 1.1034-1 (c)(4), this encompasses not only cash expenditures, but also debt to which the property is subject at the time of the purchase, liabilities that are part of the consideration, commissions and other expenses paid or incurred on the purchase of the new residence. If a taxpayer builds a new residence, only capital costs incurred during the four-year replacement period qualify as the cost of the new residence; consequently, taxpayers should consider making contractual payments for additional projects yet to be completed (e.g., landscaping) before the four-year replacement period expires. Regs. Sec. 1.1034-1 (c)(3)(ii) provides that the cost of the replacement residence does not include any portion used for nonresidential purposes (e.g., a home office).

The new residence need not be purchased with the funds received from the sale of the old residence; thus, the taxpayer may use credit to buy the new home while using the proceeds from the sale of the old home for other purposes. If the new residence is obtained through an exchange, the cost of the new residence is the FMV of the property on the date of the exchange.

Sec. 121 Gain Exclusion

Taxpayers can elect under Sec. 121 to exclude up to $125,000 ($62,500 if married filing separately) on the sale, exchange or involuntary conversion of a principal residence; the excluded gain constitutes a permanent deferral from income tax. Sec. 121(b)(2) permits the election only once during the taxpayer's life. The taxpayer must meet the following:

1. Be at least 55 years old before the date the residence is sold (Sec. 121(a)(1)).

2. During the five years prior to the sale, owned and used the property as his principal residence for a period aggregating at least three years (Sec. 121(a)(2)). The ownership/use test may be satisfied, according to Regs. Sec. 1.121-1(c), by establishing ownership and use for 36 months (or 1,095 days); short temporary absences (e.g., vacations) are counted as periods of use, even if the residence is rented during the absence.

If a married couple filing jointly owns the residence as joint tenants, tenants by the entirety or community property, Sec. 121(d)(1) allows the exclusion as long as one of the spouses meets both the requirements; thus, the exclusion is not available if one spouse meets the age requirement and the other spouse meets the ownership/use requirement. In addition, each...