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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Из курса от партнера University of Illinois at Urbana-Champaign
Federal Taxation II: Property Transactions of Business Owners and Shareholders
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University of Illinois at Urbana-Champaign
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Курс 2 из 5 — Specialization U.S. Federal Taxation
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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.
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Matthew HutchensLecturer of Accountancy
Department of Accountancy
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
Welcome back. So far,
we've looked at two major non-taxable exchanges,
like kind exchanges and involuntary conversions.
Recall that under these rules,
taxpayers could differ 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 non-taxable exchange.
Interestingly, in this non-taxable 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 the 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 and theft losses.
But again, they have to be above the $100 per event floor,
and above 10 percent 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 at 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 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 cells that first property.
That's still okay under Section 121.
So, up to $250,000 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 to your ownership test.
Second, both spouses must meet the at least two-year use requirements.
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 tests,
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 further 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 or there is 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 two 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 or maybe head of household, for example,
or $500,000 if married filing 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 in 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 qualify for section 121.
Recall that with our other non-taxable exchanges,
with light kind exchanges,
and involuntary conversions, we had to make sure we met the replacement property rules.
Here, no replacement properties required.
You can sell your house and move into a tent or onto abroad,
and still qualify for the section 121 exclusion.
Third, the basis in 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 gained,
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 forgo the exclusion.
You'd probably elect a forgo 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, and you 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 depreciation is actually not excluded under Section 121.
So, let's take a look at a few examples to illustrate
how the Section 121 exclusion works.
First, we have Mary who is 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's Section 121 allows an exclusion of gains of up to
$250,000 for non-married 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 use the property for four of the last five years,
and 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 used 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 and gain from the sale of a primary residence?
Here, Holly owned and used the house for only six 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 prorated share of
qualified time over the two years that she owned and use the home.
Therefore, Holly may exclude six-twenty-fourths or one-quarter of the $250,000 limit.
That is the non married filing joint exclusion,
or she can exclude $62,500.
Again, this exclusion I'll be at partial is
still allowed because it's a result of a divorce.
In our final example,
we have Krista who has owned and use the 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 realize a $145,000 gain.
Krista sells her resonance in December,
20x2 and realizes a gain of $378,000.
First, what has 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 reserve for married filing joint 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 two-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 realize 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 tax at preferential rates.
So, that's an unwelcome tax bill to Mary.
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 claim Section 121.
Again, if this happens,
they can have up to $500,000 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 of the last five years,
and neither spouse can be ineligible to claim this Section 121 exclusion,
because one or both of them claimed it within the last two years.
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