This course examines the U.S. federal tax system as it relates to property transactions of business owners and shareholders. Topics include cost recovery, such as depreciation, amortization, and depletion; calculation of realized versus recognized gains and losses; evaluation of the potential tax effects of nontaxable exchanges; and the combining, or netting, gains and losses that are different in nature. Assignments facilitate self-discovery of knowledge and development of a variety of professional skills.
Sale of Personal Residence
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From the course by University of Illinois at Urbana-Champaign
Federal Taxation II: Property Transactions of Business Owners and Shareholders
19 оценки
University of Illinois at Urbana-Champaign
19 оценки
Course 2 of 5 in the Specialization U.S. Federal Taxation
From the lesson
Module 6 Property Transactions: Involuntary Conversions and Tax-Free Gains
In this module, we continue our discussion regarding non-taxable exchanges and discuss involuntary conversions. You will learn the earliest and latest dates to involuntarily exchange an asset after a casualty loss or condemnation. Next, we discuss paths for conversion, direct and indirect, and their tax consequences. We discuss two tests governing the non-recognition rules, specifically the functional use test and the taxpayer use test. Last, we discuss the rules governing the non-taxation of the sale of a taxpayer’s primary residence.
Meet the Instructors
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
[MUSIC]
Welcome back, so far we've looked at two major nontaxable exchanges,
like-kind exchanges and involuntary conversions.
Recall that under these rules, taxpayers could defer, or postpone, realized gains,
such that the realized gain would be different from the recognized gain.
In this video, let's talk about a third nontaxable exchange.
Interestingly, in this nontaxable exchange,
we'll see that we will not have a postpone gain but rather an excluded gain.
That is, the realized gain will never be recognized under that tax rules.
So to begin, recall that if the sale of a personal use asset generates
a realized loss, the loss is actually not recognized.
For example if I sell my personal home at a loss, or
my personal car at a loss, or my personal furniture at a loss,
I cannot deduct that loss at all on my personal tax return.
The only personal losses we can deduct are related to personal casualty or
theft losses.
But again, they have to be above the $100 per event floor and
above 10% of our adjusted gross income.
However, on the gain side as a general rule realized gains on personal use
assets, including our principal residence, must be recognized.
Again, if I sell my personal vehicle at a gain, I must recognize the gain.
If I sell my personal furniture a gain, I must recognize that gain.
However, there is a very valuable provision in
the Internal Revenue Code Section 121 that states that the realized
gain on the sale of a principal residence, so my personal home or
apartment, can be partly or wholly excluded from income recognition.
Let's look at this provision a little more closely.
Specifically, Section 121 states, the taxpayers may exclude
the first $250,000 of gain on the sale of a personal residence.
To qualify, the rules say that the taxpayer must own and
use the property as a principal residence for
at least two years during the five year period ending on the date of the sale.
Note that the residence does not have to be owned and used,
for example, in the two most recent years of the five year period.
It could be that the taxpayer owns and uses the property for two years, then live
somewhere else for one or two or three years, and then sells that first property.
That's still okay under Section 121, and so up to $250,000
dollars in gain on the sale of the property will be excluded from income.
Now, for taxpayers that are married and filing a joint tax return the exclusion
is higher in that the first $500,000 of gain is excluded.
But to qualify, first, either spouse must meet the at-least-2-year ownership test.
Second, both spouses must meet the at least two year use requirement,
and third, neither spouse can not be ineligible for the exclusion.
Because for example,
maybe one of the spouses sold a principal residence within the prior two years,
and already claimed his or her share of the Section 121 exclusion.
As with many tax rules, there are exceptions to the own-and-use time
period that's typically required for gain exclusion under Section 121.
In other words, the taxpayer or
taxpayers might not have to meet the two-year test, but
they can still potentially exclude gain on the sale of their personal residence.
Such exceptions include a change in the place of employment.
But the distance test, as it pertains to the moving expense deduction,
must be met as we saw many videos ago.
In particular, the location of the taxpayer's new job must be 50
miles farther from the old home than the old home was from the old job.
Another exception deals with a physician's recommendation for
a change of residence, or there's an involuntary conversion like a fire.
Another exception deals with the death of a qualified individual or a divorce or
legal separation.
There are other exceptions as well, including if you or your spouse had
multiple births from a single pregnancy, like having twins or triplets or more.
However, even with these exceptions,
the full amount of the exclusion may not be available.
The amount of exclusion is prorated in terms of the number
of qualifying months over the 2 year or 24 month test period.
Here you would take the share of the 24 months that the taxpayer actually
owned and used the property.
And multiply it by the applicable exclusion limit, or
$250,000 if not married filing jointly, so single and
maybe had a house, for example, or $500,000 if married filed jointly.
Some other points here.
The amount realized is calculated as the selling price of
the personal residence minus selling expenses,
such as advertisements, commissions and legal fees.
Repairs and maintenance, for example, painting the walls or
cleaning the carpets in the house that the seller does to help sell the property, is
not a selling expense, and it does not add to the taxpayer's basis for the residence.
So you would compare the amount realized to the basis of
the house to determine the realized gain or loss.
A second point here is that the purchase of a replacement residence is not required
to quality for Section 121.
Recall that with our other nontaxable exchanges,
with like-kind exchanges and involuntary conversions,
we had to make sure we met the replacement property rules.
Here no replacement property is required.
You can sell your house and move into a tent or on to a boat and
still qualify for the Section 121 exclusion.
Third, the basis of the new residence is simply the cost of the new residence.
The basis is not adjusted based on how much gain was excluded.
We would only adjust basis to reflect a postpone gain as we did with like-kind
exchanges and involuntary conversions.
We do not have to do that here.
Fourth, the Section 121 exclusion is not automatic, but
you can elect to forego the exclusion.
You'd probably elect to forego if you believe you'll sell another property
within the next two years.
Perhaps a property that has a bigger gain, and
that could use up more of the exclusion.
Finally, any realized gain attributable to depreciation is not eligible for
Section 121 exclusion treatment.
For example, if you had a home office and depreciated it,
which then reduce the basis of your home,
to the extent realized gain is there because you depreciated your home office.
That is gain represented by the depreciation is actually not
excluded under Section 121.
So let's take a look at a few examples that illustrate how the Section
121 exclusion works.
First, we have Mary, who's single and 35 years old.
She sells her principal residence, that she purchased four years ago and
realizes a $230,000 gain.
How much of the gain can Mary exclude?
Here Section 121 allows an exclusion of gains of up to $250,000 for
nonmarried filing joint filers.
As long as they own and use the property as their principal residence for
at least two of the last five years.
In this case, Mary is single, and she has owned and
used the property for four of the last five years, therefore,
she can exclude her entire $230,000 gain under Section 121.
Now, what if Mary's realized gain is $320,000?
How much gain can she exclude now?
Again, she can exclude only the first $250,000 of gain under Section 121,
because she's not married filing jointly.
The remaining $70,000 of gain is actually a long term capital gain and
will be taxed at preferential rates.
Now, what if Mary is married to Paul, and
they have owned and occupied the residence for the last four years?
And there's a $320,000 gain, how much of this gain can be excluded?
In this case, because Mary and Paul are married filing jointly,
Section 121 allows an exclusion of gains up to $500,000.
Assuming at least one spouse owned the residence and
both spouses use the residence for two of the last five years, and
that neither spouse is ineligible to claim the Section 121 exclusion.
In our second example, Holly has lived in her first house in Los Angeles for
six months with her husband, Wood, when they get a divorce.
Get it, Hollywood?
Holly sells the house and moves to New York.
How much may Holly exclude in gain from the sale of her primary residence?
Here Holly owned and used the house for only 6 of the last 24 months.
Also, at the end of the year they're divorced, so not married, filing jointly.
Divorce is an exception to the two year ownership and
use test, but she can only exclude the gain up to the pro-rated share of
qualified time over the two years that she owned and used the home.
Therefore, Holly may exclude six twenty-fourths,
or one quarter of the $250,000 limit.
That is the nonmarried filing jointly exclusion, or she can exclude $62, 500.
Again, this exclusion, albeit partial,
is still allowed because it's a result of divorce.
In our final example, we have Krista who's owned and used a house as her
principal residence for the last 17 years, and she marries Josh in January 20x2.
Josh sold his residence, where he lived for six years,
in October, 20x1, and realized a $140,000 gain.
Krista sells her residence in December, 20x2, and
realizes a gain of $378,000.
First, what is Josh's recognized gain related to the sale of his home?
Well, notice here that Josh was single at the time he sold his
home in October, 20x1.
So what implications does this have?
So this means that Josh's Section 121 limit is $250,000,
not the $500,000 limit reserved for married filing jointly taxpayers.
But that's okay here, his gain of $145,000 happens to be less than
the $250,000 limit, so his entire gain is excluded.
He does not have to recognize any gain on the sale of his home.
Now, what is Krista's recognized gain related to the sale of her home?
Well, she sold her home in December 20x2,
which is 11 months after getting married to Josh in January 20x2.
But recall that Josh just used his Section 121 exclusion in October 20x1.
In order to qualify for the $500,000 exclusion for married taxpayers,
either spouse must meet the 2 year ownership test and
here Krista qualifies since she owned the home for the last 17 years.
And both spouses must meet the two year use test and
neither spouse cannot be ineligible to claim the Section 121 exclusion.
Here we have a problem.
Here Josh does not meet the two-year use test, and
Josh used his Section 121 exclusion in October, 20x1.
So although Mary realized a gain of $378,000,
she can only exclude the first $250,000.
The remaining $128,000 would be taxed as a long
term capital gain taxed at preferential rates.
So that's an unwelcome tax bill to marry.
Could you suggest a better tax strategy to Krista and Josh?
Well, from a strictly tax perspective, a better strategy would be for
Krista and Josh to live in the house for another year.
So Josh meets the two-year use test and
becomes eligible to claims Section 121 again.
If this happens, they can have up to $500,000 in gain to be excluded,
while Josh can still keep the exclusion he claimed on the sale of his home.
So in summary, Section 121 provides taxpayers with an outright
exclusion of gains on the sale of a personal residence.
In particular, the first $250,000 of realized gain will not be recognized, and
that exclusion limit goes up to $500,000 if taxpayers are married, filing jointly.
To qualify, the taxpayer must own and
use the property as a primary residence for two of the last five years.
While for married filing joint taxpayers, at least one spouse must own
the property and both spouses must use the property for two the last five years.
And neither spouse can be ineligible to claim the Section 121 exclusion
because one or both of them claimed it within the last two years.
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