Tax planning for the sale of a principal residence: final regulations on the principal residence exclusion clarify some issues under sec. 121 and create new tax planning opportunities.

• Author: Dilley, Steven C.
• Position: Part 1

On Dec. 23, 2002, the IRS issued final regulations on the exclusion of gain from the sale of a principal residence under Sec. 121. (1) The final regulations clarified several areas of concern in the proposed regulations and created several new tax planning opportunities to accompany the many existing under Sec. 121 and the proposed regulations. This two-part article emphasizes new opportunities created by the final regulations.

Part I, below, discusses the major rules and planning opportunities for required periods of ownership and use and how the property is used. Part II, in the February 2004 issue, will discuss how the property is owned.

Overview

Sec 121 was enacted in the Taxpayer Relief Act of 1997 and is generally effective for sales or exchanges of a principal residence after May 6, 1997. A taxpayer may exclude $250,000 of gain ($500,000 on certain joint returns) from the sale if he or she owned and used the residence as his or her principal residence for two of the five years preceding the sale date. In general, the gain exclusion may not be taken again until two years after a sale resulting in an exclusion.

Example 1: T lived in a rental apartment in Chicago, IL, until she bought her first home for $165,000 on Aug. 15, 1999 (the closing and title transfer date). The home was in Evanston, a Chicago suburb. She lived in die home until June 10, 2003, when she moved to St. Louis, MO, due to a change in employment. T initially rented a home in St. Louis. She sold her Evanston home on Dec. 5, 2003, for $320,000 and bought a home in St. Louis on Jan. 17, 2004 for $255,000. T owned the Evanston residence for 1,573 days and used it as her principal residence for 1,395 days during the five-year period of Dec. 6, 1998--Dec. 5, 2003.

Both the ownership and use numbers must be 730 days or more to exclude the gain, but do not have to be concurrent. (2) T has a $155,000 ($320,000 selling price--$165,000 basis) excludible gain on the Evanston residence sale. Because the gain is entirely excludible, she does not have to report the sale on her 2003 return. (3) T may use the proceeds from the Evanston sale for whatever she wishes; she does not have to reinvest them in another home.

While the sale of a taxpayer's home is frequently not as simple as in Example 1, the Sec. 121 rules are extremely flexible and generous in allowing gain exclusion in many complex circumstances. (4)

Tax Planning Factors

The complexities in applying Sec. 121 and its regulations arise from a taxpayer's living arrangements and how the rules treat those arrangements. Consequently, even more than usual, facts heavily drive the tax result. Generally, three categories of factors influence both planning and applying the law to a completed transaction:

1. Dates and time periods of ownership and use.

2. How the property is used.

3. How the property is owned.

Dates and Periods of Ownership and Use

The critical dates and time periods of ownership and use are: (1) when ownership began, (2) when use began, (3) when ownership ended, (4) when use ended, (5) the date three years after either ownership or use ended and (6) the length of use during a calendar year.

The Sec. 121 rules have a retroactive approach--they look back five years from the sale date. During that period, the taxpayer must have owned the property at least two years and used it as the principal residence for two years. However, for planning purposes it is better to take a prospective approach; once the residence has been owned and used as a principal residence for two years, it is an eligible principal residence for the five-year period. Consequently, the period in which the residence began to be owned and used as a principal residence is crucial.

Usually, the date ownership began can be easily determined, but when residence began is much more difficult. In Example 1 above, the closing documents determine when T began to own the Evanston house, but when did T move out of her apartment and begin living in the house? What if she did not move in immediately because she was remodeling? What if her apartment lease ran for another three months after she purchased the house? Regs. Sec. 1.121-1 (b) uses a facts-and-circumstances test to determine a taxpayer's principal residence; Regs. Sec. 1.121-1(b)(2)(i)-(vi) lists the following relevant objective factors for the use test: (5)

* The taxpayer's place of employment (not relevant to T's apartment vs. Evanston house determination);

* The principal place of abode of the taxpayer's family members (not relevant, because T is single and has no family members living with her);

* The address listed on the taxpayer's Federal and state tax returns (did not change for T until she filed her 1998 returns in 1999), driver's license and automobile registration (the date of this change is not reflected on T's driver's license or automobile registration, but may be on a receipt from the department of motor vehicles) and voter registration card (this typically has no record of when the registration was changed);

* The taxpayer's mailing address for bills and correspondence (this information is filed with the U.S. Postal Service and others, but the date of the address change is unlikely to be recorded anywhere);

* The location of the taxpayer's banks (T's bank had branches throughout the Chicago area and she did most of her physical banking in the branch near her work); and

* The location of the taxpayer's religious organizations and...