Tax planning for the sale of a principal residence.

• Author: Dilley, Steven C.
• Position: Part 2

EXECUTIVE SUMMARY

* Final and temporary regulations elaborate on the two-year ownership requirement for the Sec. 121 gain exclusion.

* In many situations, another taxpayer's ownership period is counted in meeting the principal-residence ownership requirement.

* The new temporary regulations expand exceptions to the two year ownership requirement when the primary reason for a second sale is a change of employment, health or unforeseen circumstances.

A variety of ownership situations may affect a taxpayer's eligibility for a principal residence gain exclusion. Part II of this two-part article examines rules and planning for various ownership situations, and exclusions for more than one principal residence sale during a two-year period.

In December 2002, Treasury issued final regulations to clarify the principal residence gain exclusion under Sec. 121; this two-part article focuses on rules and planning opportunities stemming from the new rules. Part I, in the January 2004 issue, focused on how the property is used and the required periods of use. Part II, below, examines various ownership situations affecting a taxpayer's eligibility for the exclusion. It also discusses gain exclusions for taxpayers who have to sell more than one principal residence during a two-year period.

How the Property Is Owned

Generally, a taxpayer must own the property for at least two years prior to sale to qualify for a Sec. 121 exclusion. However, there are many situations when another taxpayer's ownership helps maximize the exclusion. Below is a list "ownership" situations to consider in tax planning or when filing a return for a completed transaction:

* Same owner and user.

* One owner and more than one user.

* Multiple owners, but only one owner-user.

* Multiple owners and multiple owner-users.

* Special owners (e.g., trusts, limited liability companies (LLCs), bankruptcy estates, cooperatives and deceased or former spouses).

* Partial sales.

* Replacement property.

Same Owner and User

A single owner-user living in the residence is a very common situation that is usually uncomplicated. (22)

One Owner and Multiple Users

The use of the property by anyone other than a spouse (or former spouse) of the taxpayer-owner does not "count" toward the latter's use of the property. For example, in Kegs. Sec. 1.121-1(c)(4), Example (2), the taxpayer-owner bad not met the two-year use test when she ceased to use the property as her principal residence, but her son continued to live there. The son's use of the property did not count towards her use of the property.

An even more common illustration is a couple who Eves together. Under Kegs. Sec. 1.121-2(a)(3), a nonowner-spouse's use of the other spouse's property as the principal residence increases the gain exclusion to $500,000 if the couple files a joint return. However, if the nonowner is not a spouse, the use of" the property by the nonowner "significant other" does not help the taxpayer owner's gain exclusion. Thus, the key question is: where is the nonowner's principal residence? Is it the taxpayer-owner's principal residence or some other residence? If it is some other residence, the nonowner may qualify for gain exclusion on that other residence. (23)

Multiple Owners with One Owner-User

A residence may have multiple owners, but only one owner-user. Such situations can include either joint ownership or tenant-in-common ownership and may or may not involve married taxpayers.

Example 1: T and M, a married couple, work in different cities, T in Atlanta, GA, and M in New Orleans, LA. They own residences jointly in both cities. They sell the New Orleans house when M gets a job transfer to Atlanta. Their realized gain is $334,000.

T meets the ownership, but not the use, test for the New Orleans property and, thus, does not qualify for a gain exclusion. On their joint return for the year of sale, T and M should report a taxable gain of $84,000 ($334,000-$250,000), because they are entitled to exclude the sum of each spouse's dollar limit amount, determined on a separate basis, as if they had not been married (zero for T, $250,000 for M).

Multiple Owners and Multiple Owner-Users

What if more than one person owns the property and they all meet the ownership and usage tests? Can they each receive up to a $250,000 exclusion or is there just one $250,000 ($500,000 on a joint return) exclusion .for the property? When there are multiple qualified owner-users, the $250,000 limit is per taxpayer, not per property.

Example 2: J, M and S are unrelated individuals. They purchase a house as tenants in common, live in it for at least two years and sell it for an $810,000 gain.

Each meets the ownership and use tests and each has a $250,000 excluded gain and a $20,000 included gain on their individual returns for the year of sale. Regs. Sec. 1.121-2(a)(1) states: "A...