Selling a principal residence after the TRA '97.

• Author: Adkins, Neil
• Position: Taxpayer Relief Act of 1997

Congress has cleaned house in the Taxpayer Relief Act of 1997, by repealing the Sec. 1034 residence sale gain deferral provisions and the Sec. 121 $125,000 gain exclusion for taxpayers age 55 and older. Instead, there is now an opportunity to exclude up to $250,000 of gain ($500,000 if married filing jointly) on the sale of a personal residence, as often as every two years. This article explains the now provisions and offers planning strategies.

After nearly half a century, Congress has remodeled the tax rules for homeowners who plan to sell a principal residence. The Taxpayer Relief Act of 1997 (TRA '97), Section 312(b), repealed the Sec. 1034 rollover provisions, which allowed taxpayers to defer the gain on a sale or exchange of a principal residence to the extent the sales proceeds were reinvested in a new residence. TRA '97 Section 312(a) repealed the Sec. 121 once-in-a-lifetime $125,000 gain exclusion on the sale of a principal residence for taxpayers age 55 and over. Sec. 121 (b), as amended, permits individuals meeting ownership and use tests to exclude from taxable income up to $250,000 of gain ($500,000 if married filing jointly) each time they sell or exchange their principal residence.

Many taxpayers will benefit greatly from these changes; the tax consequences on the sale of a principal residence will be eliminated for nearly 99% of all Americans selling their homes.(1) Thus, taxpayers who move to a less expensive home, relocate to a less costly area or decide to rent may no longer be required to recognize gain on the sale of their personal residences. Other taxpayers will find little or no tax benefit under the TRA '97 on the sale of their principal residences (e.g., homeowners experiencing a loss on sale). Homeowners with gains in excess of the exclusion amounts, and those using their principal residence in part as a rental or business property, will no longer find favorable deferral provisions in the Code. However, the TRA '97 does create a category of transition taxpayers who can choose between applying (1) pre-TRA '97 Sec. 1034 or 121 and (2) post-TRA '97 Sec. 121.

This article explores the TRA '97 provisions, explains the rules for certain transition taxpayers under the new law, and provides planning suggestions for maximizing the tax benefits associated with the sale of a principal residence.

Prior Law

Pre-TRA '97 Secs. 121 and 1034 required careful navigation to maximize the gain deferral or exclusion.(2) Generally, Sec. 1034(a) allowed for gain nonrecognition on the sale of a principal residence, if (1) the purchase price of the new residence was at least as much as the adjusted sales price of the old and (2) the new residence was occupied by the taxpayer beginning within two years before and ending within two years after the sale of the old residence. Any gain not recognized under Sec. 1034 reduced the taxpayer's basis in the new residence under Sec. 1034(e).

Pre-TRA '97 Sec. 121 allowed a taxpayer age 55 or older, to exclude from gross income up to $125,000 of the gain realized on the sale of a principal residence, as long as the residence was used as his principal residence for at least three of the five years immediately before the sale. This election was available to a taxpayer only once during his life. Because Sec. 121(c) required married couples to make the election jointly, this provision often created complex and inequitable predicaments for widowed or divorced senior citizens who desired to remarry and one of the new partners had previously made the election with a former spouse.

The TRA '97

In general, the new Sec. 121 exclusion is allowed for each sale or exchange of a principal residence that has been treated as a principal residence for at least two of the preceding five years. The taxpayer must have owned and used the property as his principal residence for at least two years during the five-year period ending on the date of the sale or exchange ("ownership/use tests"). According to Sec. 121(b)(3) (A), the exclusion is allowed each time a taxpayer who sells or exchanges a principal residence meets the eligibility requirements, but generally no more often than once every two years. For a taxpayer who acquired his residence in a transaction covered by pre-TRA '97 Sec. 1034, new Sec. 121 (g) provides that the periods of ownership and use of the prior residence are taken into account in determining ownership and use of the current residence.

Example 1: S, who is single, sold her principal residence of 10 years on May 1, 1996 and deferred gain recognition under Sec. 1034. On the same day, S purchased and occupied a new residence, which she sold on Sept. 1, 1997. Under post-TRA '97 Sec. 121 (g), S's holding period in, and use of, her new residence is 11 years, four months. S qualifies for an exclusion of up to $250,000 of gain when she sells the new residence.

Reduced Exclusion

According to Sec. 121(c), if the ownership/use tests are not met for certain reasons, the exclusion is based on a ratio of the number of qualifying months to 24 months.(3) Specifically, under Sec. 121 (c) (2) (B), a taxpayer is entitled to a prorated exclusion if he fails to meet the ownership/use tests because of a change in place of employment, health or other unforeseen circumstances.(4) The prorated amount is the ratio of the aggregate amount of time the taxpayer actually owned and used the...