Tax planning for the personal residence in the context of divorce and remarriage: favorable tax provisions concerning property take on special significance in marital rearrangements.

• Author: Harris, Richard W.

Favorable Tax Provisions Concerning Property Take on Special Significance in Marital Rearrangements

It is often said that buying a home is the best investment most individuals will ever make. In addition to being able to live in the home, the owner has the advantage of a variety of beneficial income tax provisions involving the purchase, ownership and sale of a "principal residence." Those tax deductions, deferrals and exclusions designed to encourage and foster home ownership take on special significance when applied in the context of a pending marriage, divorce or remarriage.

Taxation of Principal Residences

In general, the definition of a principal residence is the same throughout the tax provisions concerning such property. Although a taxpayer may own many personal residences, only one of them may qualify as his principal residence at any particular time.(1) In addition to the typical house, personal residences may include cooperatives, condominiums, trailers, mobile homes, houseboats and even yachts.(2)

When a taxpayer owns and uses several personal residences concurrently, the determination of which one qualifies as the principal residence is based on all relevant facts and circumstances.(3) Under the most prominent criteria, the residence that is occupied the majority of the time will generally be viewed as the taxpayer's principal residence.(4) Also, the courts often evaluate traditional domiciliary indicia in order to determine the taxpayer's principal residence in multiple residence situations. For instance, in Thomas,(5) the taxpayer concurrently owned four personal residences that were occupied at various times during the year. Three of the homes were located in Florida and one in Illinois. The Tax Court determined the Illinois home to be the taxpayer's principal residence since he used it more than any of the others, and because his only business was located there, he filed state income tax returns there, and his wife was registered to vote, contributed to and attended church and had her only driver's license in Illinois.

If a portion of the principal residence is used for purposes other than the owner's abode (i.e., as rental property or in connection with a trade or business), only that portion used as a principal residence is subject to the favorable treatment accorded principal residences.(6)

Among the most notable general tax benefits available to owners of a principal residence, not significantly affected by the prospect of marriage or divorce, are:

"Points": In connection with a mortgage obtained for the purchase or improvement of a taxpayer's principal residence, points are deductible in full as interest in the year paid. In order to qualify, the points paid must not exceed those normally charged pursuant to established business practice in the locale and the indebtedness must be secured by the residence.(7)

Real estate taxes: A purchaser or seller of any real property, including a principal residence, is entitled to deduct the proportionate share of state and local real estate taxes applicable to the portion of the tax year the property is owned by the taxpayer (whether or not such taxes are adjusted or reimbursed at settlement).(8)

Home mortgage interest: With certain limitations, a deduction is allowed for "qualified residence interest" attributable to the aggregate cost (not to exceed $1 million) of acquiring, constructing or substantially improving, plus $100,000 of aggregate equity in, the taxpayer's principal residence and one other qualified residence.(9)

Rollover of Gain on Sale of a

Principal Residence

Sec. 1034(a) permits the deferral of all or a portion of the gain realized on the sale of a principal residence when the taxpayer acquires (by purchase or construction) and uses a new home as his principal residence within the period beginning two years before, and ending two years after, the sale of the old residence.

Example 1: J sells his principal residence on Aug. 14, 1992. A new principal residence acquired and occupied during the four-year period beginning Aug. 15, 1990 and ending Aug. 13, 1994 qualifies J for Sec. 1034 deferral treatment on the sale of the old residence.

Except for members of the U.S. Armed Forces and, under certain circumstances, persons living outside the United States,(10) there are no exceptions or extensions to the two-year replacement period. The Service and the courts have consistently enforced the statutory replacement period strictly, denying a variety of arguments concerning situations beyond taxpayers' control that prevented the timely acquisition, construction or occupation of the new residence.(11)

Under Sec. 1034(b), the taxpayer recognizes gain only to the extent that the adjusted sales price for the old residence (the amount realized on the sale less fixing-up expenses(12)) exceeds the cost of purchasing or constructing(13) the new residence. Obviously, the acquisition of a new residence costing more than the adjusted sales price of the old residence results in complete deferral of gain. However, gain is recognized to the extent the replacement cost is less than the adjusted sales price (not to exceed the amount of the realized gain).

The taxpayer's basis in the new residence is equal to the cost of the new residence less the amount of deferred gain (i.e., the gain realized, but not recognized) on the sale of the old residence. See Example 2 on page 667.

$125,000 Exclusion From Gain on Sale

of Principal Residence

for Taxpayers Age 55 and Over

Sec. 121 permits taxpayers age 55 years or older to elect a once-in-a-lifetime exclusion of gain from the sale of a principal residence, up to a maximum of $125,000.(14) In order to qualify, the taxpayer must meet certain age and holding and use requirements. The taxpayer (or spouse, if the residence is owned jointly and a joint return is filed) must have attained age 55 before the date of the sale, and must have owned and used the home as his principal residence for time periods aggregating at least three years during the five-year period immediately preceding the sale.(15)

An unmarried widow or widower not meeting the holding and use requirement is nevertheless entitled to make the election under Sec. 121(d)(2), if (1) that individual meets the age test and (2) his or her deceased spouse satisfied the holding and use requirement on the date of sale and had never made an election under Sec. 121.

Example 3: J, age 70, has lived in his home for over 20 years. In January 1993, J marries W, age 57, who immediately moves into J's home. J dies in late 1993 and W sells the home in early 1994 at a considerable gain. W may elect the Sec. 121 exclusion. She is deemed to pass the Sec. 121 occupancy test since her husband's previous occupancy was qualified under Sec. 121 as of the date of sale.

If elected, Sec. 121 excludes gain up to a maximum of $125,000 ($62,500 on a separate return by a married taxpayer). However, once used, the exclusion is no longer available even if the gain excluded was less than the maximum allowed. Thus, a taxpayer selling a principal residence for a $40,000 gain (and planning to acquire a replacement residence) should carefully consider whether to make the election or, alternatively, defer the gain under Sec. 1034 and use the Sec. 121 exclusion in conjunction with a later sale of the new residence - possibly excluding a larger amount of gain on the subsequent sale. The age and health of the taxpayer are obvious factors to be considered since the three-out-of-five-year occupancy test must be met with regard to the new home before its sale in order to qualify under Sec. 121.

When the sale of a taxpayer's principal residence produces gain in excess of $125,000, the Sec. 121 exclusion may be used in combination with the deferral of gain under Sec. 1034. The taxpayer simply excludes $125,000...