How to Secure a Personal Home Exclusion Tax Break

Contributed by BSCAI

While the process of selling a home can be very stressful, sellers should be excited as it often symbolizes a new chapter in life. What if there was also a tax code that could make this even more exciting? Under Internal Revenue Code (IRC) Section 121, sellers can exclude up to $250,000 of the gain from the sale of their residential home. This number is $500,000 if the seller is a married couple who files jointly. 

As expected, like any other tax break, this personal home exclusion has a strict set of rules that need to be followed precisely in order for the sale to qualify. For example, those who fail to maintain their home ownership within these set parameters could be disqualified from the tax exclusion. This would then, consequently, cost sellers thousands of dollars in taxes.  

To make sure sellers qualify, there are many facets of these requirements that must be considered. The first and most important rule is that the exclusion only applies to the sale of the principal residence. A person is only eligible to have one principal residence at a time. The IRS determines this with a “fact and circumstances” test.  

For those who happen to own multiple residential properties, be sure to take extra steps to ensure that it is the “principal residence” that is for sale. For example, be sure to list the home address on relevant documents such as tax returns, driver’s licenses, voter ID cards, etc. Sellers could also become a member of clubs or groups near this home. While it is not a necessity to do all of this, the more a person is able to associate with the home the better. 

There is an “Eligibility Test” promulgated by the IRS. The first step is an “automatic disqualification”. This happens if a person acquired their home through a 1031 exchange within the past five years. There is a second automatic disqualification when a person is subject to expatriate tax. 

For the second step, “ownership”, things can get more complicated than it sounds. It is vital that a person own the home for at least two out of the past five years immediately before the sale. What exactly does it mean to “own” the home in this step? First, if an individual or at least one of the spouses owns the home outright, they've passed the test. However, if that person only owns a remainder interest in the home, the sale will only qualify if the buyer is not a related party and "the owner” has not already sold an interest in the home.  

Now, what if the home happens to be owned by a business? A single-owner entity that is not treated separately from its owner for tax purposes, like an LLC for example, can sell a residence and be able to qualify for the exclusion. This sale would still be treated as a sale by the owner since the entity and owner are not treated separately for other tax purposes. If the sale were to be done through an S-Corp or a C-Corp, the sale would not qualify because the exclusion is designed to benefit individuals and not businesses. 

Ready for it to become even more complicated? When a property is held in a trust, only if the individual is treated as the “owner” of the trust under the IRC will the sale by the trust be eligible for the exclusion. The IRC provides certain rules of ownership under which grantor trusts and revocable trusts generally are treated as owned by the individual grantor, thus making them qualify for the exclusion. If the grantor is not considered to be the “owner”, such as in an irrevocable trust, then the sale by the trust would not qualify. 

Going into the third step, “residence” considers how the property is used. As stated before, the owner must use the home as a residence for at least two of the five years immediately before the sale. In terms of spouses, each individual must meet the residence requirement. Any short absences, such as vacations, will not count against the time. Also, if the owner happens to use the property for business or rental purposes, their ability to claim the exclusion will not be destroyed so long it is not being used for those purposes at the time of the sale. These circumstances could affect the exclusion calculation, however. Any “business or rental percentage” of the home use for these purposes will be deducted from the exclusion benefits. 

An exception to the residency rule is if the owner were to become physically or mentally unable to care for themself. The rules can then be altered and so long as they spend 12 months using the residence as their principal residence in the five years preceding the sale or exchange, any time that is spent living in a care facility counts toward the two-year residency requirement. That is dependent upon the facility having a license from a state or other political entity to care for people with their condition. 

The exclusion is eligible to apply to many different types of housing facilities. A single-family home, a condominium, a cooperative apartment, a mobile home, and a houseboat each may be the main home and therefore qualify for the exclusion. 

The fourth and final step is the lookback period. This step says if a person sold another home within the two years prior to this sale, and they took a home exclusion on that prior sale, then they will fail the lookback period test. 

If you are looking into selling your home and have any questions about the Personal Home Exclusion, reach out to the professionals at The Center for Financial, Legal, and Tax Planning, Inc at www.taxplanning.com or by phone at (618) 997-3436.