By Lisa K. Cagle
Research and Writing Editor, American Journal of Trial Advocacy
Moving. . . the word conjures up feelings of anxiety, excitement, or even remorse. In the United States, most people will move at some time during their lives.[1] In fact, over 35 million Americans move annually[2] with many moves involving the sale of the home.[3]
Moving is expensive; whether a person hires professional movers or loads everything into a pickup truck, moving costs money. An average move costs $4,300 to relocate to a new state or $2,300 to relocate within the same state,[4] not exactly pocket change for most people. However, if the move involves the sale of a home, the sale may trigger capital gains taxes. A capital gain results when the sales price of a capital asset—for example, a house—is more than the cost to the owner.[5]
Fortunately, the IRS has also provided a means to allow a taxpayer to keep much of the profit from the sale of his or her home.[6] Let’s begin the journey into the world of capital gains by following the fictional story of Matthew. Matthew bought a house in 2004 for $100,000 and resided in that house for 10 years before selling that house in 2014 for $210,000. The $110,000 profit is considered capital gains, and, without an exclusion, Matthew would have to pay taxes on this $110,000. Fortunately for Matthew, the Home Sale Gain Exclusion exists and allows Matthew to exclude up to $250,000 ($500,000 if married filing jointly) in capital gains from the sale of his principal residence. This article will discuss the requirements of eligibility for the Home Sale Gain Exclusion.
The Home Sale Gain Exclusion
The Home Sale Gain Exclusion allows a taxpayer to exclude up to $250,000 ($500,000 if married filing jointly) from capital gains on the sale of the taxpayer’s main home once every two years.[7] To be eligible for this exclusion, the taxpayer must meet two requirements: use and ownership.[8] Additionally, these requirements do not need to be met concurrently to be eligible for the Home Sale Gain Exclusion. [9]
The first requirement states that the house is the main place where a person resides, also known as the principal residence.[10] This is what the IRS terms the “use requirement.”[11] Reasonable absences such as vacations and short-term hospital stays do not alter the location of a principal residence.[12] Additionally, the principal residence does not have to be a house. It could include a boat, a trailer, or even a vacant lot, provided the vacant lot was owned and used as part of the principal residence.[13] However, caution must be advised. Although the IRS defines “residence” broadly, not all residences may qualify under the Home Sale Gain Exclusion. In particular, a mobile home, under local laws, may not be considered a fixture, and, therefore, not qualify as a residence for purposes of the Home Sale Gain Exclusion.[14]
Additionally, the principal residence must be the primary residence. While over three million Americans own a second home,[15] the only residence that qualifies for the Home Sale Gain Exclusion is the primary residence: the one where the individual lives the majority of the year.[16]
The second requirement is the “ownership requirement.”[17] As the name suggests, this requires that the taxpayer owned the residence.[18] Notably, for a couple that is married filing jointly, only one of the spouses must have owned the residence for the required period of time.[19]
Finally, merely using and owning a residence is not enough to qualify for the Home Sale Gain Exclusion. There is also a time element involved: the taxpayer must have used and owned the residence for two out of the last five years dated from the time of the sale, known as the “test period.”[20] As previously stated, the use and ownership requirements do not have to be met concurrently, however, both must be met during the requisite five-year test period.[21] As an illustration, fictional character Jenny rented her house from 2011-2014, then purchased it and lived in it from 2014-2016, after which she moved out and rented it to another individual, while still retaining ownership. In 2018, Jenny decide to sell the house. Jenny meets the ownership requirement because she owned the house from 2014-2018: 4 years. She also meets the use requirement because she used the house as her primary residence from 2011-2016. Note that, for the purposes of the Home Sale Gain Exclusion, only the 5 years preceding the date of the sale may be applied; fortunately for Jenny, she still meets the use requirement because she lived in the house for 3 years during the test period (2013 is 5 years before the sale of the house and, using this as a starting date, Jenny lived in the house from 2013-2016: 3 years). Therefore, Jenny is likely eligible for the Home Sale Gain Exclusion.[22]
The Home Sale Gain Exclusion also applies to married couples. As an illustration is fictional married couple Sam and Susie. Sam purchased his house in 2010 and Susie moved into the house in 2011. In 2012, Sam and Susie got married to each other and Susie’s name was placed on the deed for the house. Then, in 2014, Sam and Susie sold their home. How does this effect their eligibility for the Home Sale Gain Exclusion? The IRS requires that only one spouse meet the ownership requirement:[23] in our example, Sam owned the home for 4 years prior to the sale, hence meeting the ownership requirement. However, the IRS requires that both spouses meet the use requirement.[24] In our example, Sam used the house for 4 years (2010-2014) and Susie used the house for 3 years (2011-2014). Therefore, as long as neither Sam nor Susie have used the Home Sale Gain Exclusion on a different residence in the previous two years, Sam and Susie will likely qualify for the Home Sale Gain Exclusion.[25]
Military Family Tax Relief Act
Of course, not every individual can meet these requirements, and often military families are required to move before they become eligible for the Home Sale Gain Exclusion. Under the correct circumstances, the IRS allows the five years to be suspended. Under the Military Family Tax Relief Act of 2003 (MFTRA), “a member of the uniformed services or of the Foreign Service of the United States” who “is serving on qualified official extended duty” may suspend the five years for up to an additional ten years.[26] Qualified official extended duty means the individual (1) has been “called or ordered to active duty for an indefinite period, or for a definite period of more than 90 days,” (2) is serving more than 50 miles from their “main home,” and (3) is a member of the armed forces, Peace Corps, Foreign Service, or intelligence community.[27]
To explain ten-year suspension, let’s take a look at military couple Marco and Maddy. In 2003, Marco and Maddy were stationed in Grand Forks, North Dakota, where they bought and lived in a home. In 2006, the military couple were transferred to Andrews Air Force base, located in the deserts of southern California. Due to the less favorable real estate market near Andrews Air Force base, the couple decided to live on base and rent out their Grand Forks house. In 2014, after a boom in the Grand Forks real estate market, Marco and Maddy, who are now stationed at yet another military base, decide to capitalize on the Grand Forks market and sell their Grand Forks house. Using the suspended period provided under MFTRA, our fictional military couple are still likely eligible for the Home Sale Gain Exclusion. They meet both the ownership and use requirements: both Marco and Maddy lived/used and owned the home for 3 years (2003-2006). They also meet the qualified official extended duty requirements: (1) they are on active duty, (2) they are stationed at least 50 miles from their house, and (3) they are a member of the uniformed services, in this case, the Air Force. Therefore, Marco and Maddy may suspend their five years by up to ten years. This means that Marco and Maddy may suspend the five years for the 8 years they were on qualified official extended duty (2006-2014). The IRS describes this as “disregarding those [8] years.”[28] Because Marco and Maddy owned and used the home for more than 2 of the 5 years during the test period (ownership from 2003-2006 for a total of 3 years), Marco and Maddy are likely eligible for the Home Sale Gain Exclusion.
When moving isn’t your choice—Partial Exclusion of Gain
Many moves are necessitated due to reasons beyond an individual’s control. According to the U.S. Census Bureau, almost 10% of annual moves are due to a new job or a job transfer.[29] Another 5% are due to a change in marital status.[30] The IRS provides three exceptions that allow individuals to claim a partial exclusion of gain on their home when they are unable to meet all the requirements of the 2-out-of-5-year test.[31] According to the IRS: “You may qualify [for an exception] if you can demonstrate the primary reason for sale, based on facts and circumstances, is work-related, health-related, or unforeseeable.”[32]
The three exceptions are not broadly interpreted and are provided when the move is necessitated by a hardship. The first exception, work-related, is permitted if the new job is at least 50 miles farther from the taxpayer’s residence than the previous job.[33] The second exception, health-related, permits a partial exclusion of gain when the move was facilitated due to a personal illness requiring relocation closer to a healthcare provider, or if a family member’s illness required the taxpayer to relocate closer to “provide medical or personal care.”[34]
The third exception allows for a partial exclusion of gain if an individual underwent some unforeseen circumstance or hardship. The IRS provides some guidance on the types of situations it considers to be “unforeseen.” An unforeseen circumstance that causes an individual to move is “the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home,” such as natural disasters, acts of terrorism, death, divorce, or multiple births from the same pregnancy.[35]
Conclusion
Moving is expensive, but fortunately, the sale of a primary residence can be allowed some tax breaks. Under the Home Sale Gain Exclusion, individuals who have owned and used a house as the primary residence for at least two of the five years immediately preceding the sale may exclude up to $250,000—or $500,000 if married filing jointly—of the capital gains from the sale of the house as taxable income.
[1] 35 Interesting Moving Industry Statistics for 2018 and Beyond, Simply Self Storage (Oct. 31, 2017),https://www.simplyss.com/blog/moving-statistics/ [hereinafter “Simply Self Storage”].
[2] Simply Self Storage, supra note 1.
[3] See Number of Existing Homes Sold in the United States from 2005 to 2019 (in Million Units), Statista (Feb. 2018), https://www.statista.com/statistics/226144/us-existing-home-sales/ (showing that 5.51 million homes were sold in the U.S. in 2017).
[4] Simply Self Storage, supra note 1.
[5] Topic Number 409 – Capital Gains and Losses, IRS (Mar. 13, 2018), https://www.irs.gov/taxtopics/tc409.
[6] William Perez, Paying Capital Gains on the Sale of Your Home, The Balance (June 8, 2018),https://www.thebalance.com/sale-of-your-home-3193496; see also 26 I.R.C. § 121 (West 2018) (“Gross income shall not include gain from the sale . . . if, during the 5-year period ending on the date of the sale . . . such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.”).
[7] Publication 523 (2017), Selling Your Home, IRS (Feb. 16, 2018), https://www.irs.gov/publications/p523 [hereinafter “IRS”].
[8] IRS, supra note 7.
[9] Topic Number 701 – Sale of Your Home, IRS (Feb. 1, 2018),https://www.irs.gov/taxtopics/tc701 [hereinafter “Sale of Your Home”].
[10] Walter D. Schwidetsky, Exclusion of Gain on the Sale of a Principal Residence, Interest Deductions, Home Office Rules, 8, American Bar Association, https://www.americanbar.org/content/dam/aba/events/real_property_trust_estate/symposia/2007/schwidetzky.authcheckdam.pdf (last visited Aug. 1, 2018).
[11] Sale of Your Home, supra note 9.
[12] IRS, supra note 7; Schwidetsky, supra note 10, at 3.
[13] IRS, supra note 7; Schwidetsky, supra note 10, at 2.
[14] Logan Allec, Home Sale Gain Exclusion Rules Under Section 121: How Does the Primary Residence Tax Exemption Work?,Money Done Right (Jan. 22, 2018), https://moneydoneright.com/home-sale-gain-exclusion/; see also Norris v. Thomas, 215 S.W.3d 851, 859 (Tex. 2007) (finding that “dock-based umbilical cord providing water, electricity, and phone service may help make a boat habitable” but did not qualify the boat as a residence for tax purposes).
[15] Number of Households With People Who Own a Second Home in the U.S. 2018 to 2020, Statista(July 2018),https://www.statista.com/statistics/228894/people-living-in-households-that-own-a-second-home-usa/.
[16] Allec, supra note 14; see also IRS, supra note 7 (explaining the “facts and circumstances” test to “determine which property is
[the taxpayer’s]
main home”).
[17] Sale of Your Home, supra note 9.
[18] IRS, supra note 7.
[19] Id.
[20] Id.
[21] Sale of Your Home, supra note 9.
[22] This illustration does not factor in nonqualified use that may impact the amount eligible for the Home Sale Gain Exclusion.
[23] IRS, supra note 7.
[24] Id.
[25] This illustration presumes that Sam and Susie did not use their home for other nonqualified uses.
[26] Military Family Tax Relief Act of 2003 § 101(a), 26 I.R.C. § 121(d)(9)(A) (West 2018).
[27] IRS, supra, note 7.
[28] Id.
[29] CPS Historical Migration/Geographic Mobility Tables, United States Census Bureau, Table A-4 (June 12, 2018),https://www.census.gov/data/tables/time-series/demo/geographic-mobility/historic.html.
[30] Id.
[31] IRS, supra note 7. For guidance on calculating a partial exclusion of gain, see id. (providing charts and step-by-step guidance in calculating capital gain).
[32] IRS, supra note 7.
[33] Id.
[34] Id.; see also IRS, supra note 7 (stating that a health-related event occurs when the move is (1) “to obtain, provide, or facilitate diagnosis, cure, mitigation, or treatment of disease, illness, or injury for yourself or a family member”; or (2) “to obtain or provide medical or personal care for a family member suffering from a disease, illness, or injury”).
[35] IRS, supra note 7.
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