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Planning to Sell a Home?
Brian Wainscoat, CPA
Manager, Tax Services
April 20, 2009
Good fortune happens when opportunity meets planning―and Erin and Jed have been fortunate. The couple bought their first home together nearly forty years ago and successfully invested in real estate throughout their marriage. In spite of the recent downturn, they've built significant equity in several homes.
As part of their plan for retirement, Erin and Jed intend to sell their waterfront home in a few years. They'll move into the downtown Seattle condo they originally bought for their son, now that he's moved into a home of his own. Erin and Jed will live in the condo for at least two years as their principal residence. Then, when Jed retires, they'll move permanently to the family vacation home on Bainbridge Island.
By living in each home for two years or more prior to sale, Erin and Jen intend to shelter much of the gain on each home from federal income tax. Unfortunately, changes to federal tax laws have now complicated their plans.
Pre 2009 Rules for Excluding Gain from the Sale of a Personal Residence
Until 2009, you could generally exclude up to $250,000 in gain from the sale of a personal residence―$500,000 for a married couple―as long the home was your principal residence for two of the last five years. (Special rules apply if you've taken depreciation deductions related to a home office or other business use of your home.)
As a result of these tax rules, if you owned multiple homes you could live in each home for two years immediately before the sale and exclude up to $500,000 for each. And if you owned three homes, you could potentially exclude up to $1,500,000 in gain during a six-year period.
Although Congress clearly intended that under most circumstances you could sell your home without incurring a significant federal income tax liability, this approach apparently went beyond the original intent. Beginning in 2009, the home-sale exclusion rules have been restricted for homes that did not function as the owners' primary residences during the entire period of ownership.
New Requirements for Excluding Gain
If you're selling a home that was not your primary residence during the entire time you owned it, the home-sale rules are now a bit more complicated. The two-of-the-last-five-years rule still applies and you can still exclude a maximum of $500,000 in gain from the sale. However, in determining actual amount of the gain to exclude from federal income tax for a sale after 2008, you must now allocate the total gain based on periods of qualifying and nonqualifying use.
Qualifying refers to a home's use as the owner's primary residence. Nonqualifying is any use by the owner, spouse, or former spouse other than as the primary residence―for example, a rental unit, second home, or vacation home. Significantly, the concept of nonqualifying use was not implemented retroactively. Periods of otherwise-nonqualifying use that occur before January 1, 2009 are not considered in the exclusion calculation. Temporary absences are also not considered to be nonqualifying, as long as they occur after the home has been used as a primary residence and do not, in total, represent a period of more than two years. There are other exceptions for periods of military or government service.
To calculate the excludable gain eligible for the $250,000/$500,000 maximum, you multiply the total amount of the gain by the ratio of qualifying use to total ownership. In other words, Excludable Gain = Total Gain * (Period of Qualifying Use / Total Period of Ownership).
Implications of the New Requirements
Prior to 2009, the total period of ownership―including those periods where a home served as other than primary residence―was not a factor in calculating excludable gain. Generally, as long as your home was your primary residence for at least two of the last five years, you qualified for the maximum gain exclusion. The general tax-minimization strategy was simply to live in the home for two years prior to selling it. If you owned multiple homes, that meant living in each for a minimum of two years.
Beginning with 2009, the tax strategy changed to one that maximizes the percentage of time the home serves as primary residence.
The Tax Consequences for Erin and Jed
Under the new tax rules, there are significant tax consequences for Erin and Jed if they wait three years to sell their waterfront home, as demonstrated by the two scenarios that follow. For each, assume that the waterfront home is currently worth $1,500,000 and has a tax basis of $400,000. The downtown Seattle condo, which the couple has owned for four years, has a tax basis of $250,000.
 Scenario One
If Erin and Jed sell their home and move to the condo this May, they can exclude $500,000 of the gain. The total gain on the sale of their home is $1,500,000 - $400,000, or $1,100,000. The maximum gain excludable for tax purposes is $500,000.
In another two years the couple can sell their condo and exclude another $500,000 in gain. The total gain from the sale of the condo is equal to $550,000―a selling price of $800,000 less the $250,000 tax basis. In two years, they will have owned the condo for a total of six years (72 months), of which all but four months (i.e., those after January 1, 2009 and before the condo became their principal residence) are considered qualifying use. The potentially excludable gain is $519,444 [or $550,000 * (68/72)], reduced to the maximum of $500,000 for tax purposes.
Scenario Two
Now assume Erin and Jed follow the original plan and wait another three years before selling their home and moving into the condo. Once again, they can exclude the maximum of $500,000 for tax purposes on the sale of their home―assuming that its value has not fallen below $900,000. The entire period of occupancy is a qualifying use.
Two years after the sale of their house, the couple sells the condo when the value has increased to $840,000. The total gain from this sale is $590,000, or ($840,000 - $250,000).
At the time of sale, Erin and Jed will have owned the condo for a total of nine years (108 months)―three years and four months of which are considered nonqualifying use after January 1, 2009. As a result, the period of qualifying use is only 68 months, 40 months are nonqualifying. The excludable gain on the condo sale is $371,481, or [$590,000 * (68/108)], even though the total gain is significantly higher.
As a result of the extended period of nonqualifying use, although the selling price of the condo increased by $40,000, the couple lost a federal tax exemption in the amount of $128,519 ($500,000 - $371,481). They will also have increased the period of nonqualifying use for their Bainbridge Island home by three years, should they eventually decide to sell.
You should know that, regardless of the new tax requirements, if your home's value is sufficiently high the period of nonqualifying use may be irrelevant. For example, if Erin and Jed's condo had increased in value to $1,100,000, the couple would have been able to exclude the $500,000 maximum regardless of the nonqualifying use period. In this case, the gain exclusion calculation is [($1,100,000 - $250,000) * (68/108)], or $535,185, well over the maximum excludable amount in spite of the allocation.
Finally, note that these home-sale exclusion rules represent just one of a number of tax-related rules and financial strategies that you should consider before selling your home. The analysis required to maximize the financial benefits from any real estate investment can be quite complex, so be sure to consult with your tax advisor at Bader Martin before committing to any real estate transaction.
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