Russell Duza, MBA, MS
Partner | Financial & Tax Strategist
Take Advantage of the Prorated (Reduced) Gain Exclusion Loophole for “Premature” Sales
What happens when you
fail to pass the principal residence gain exclusion ownership and use tests explained in Part 1 of our analysis, or
run afoul of the anti-recycling rule explained also in Part 1?
Are you just flat out of luck for the gain exclusion? Maybe not.
For example, perhaps you are selling your home for a big profit after living there for only 18 months instead of the required two years, so you fail the ownership and use tests. Or you might be selling your current home less than two years after excluding gain from the sale of a previous residence, so you violate the anti-recycling rule. Beat it!
Don’t give up hope.
IRS regulations allow you to claim a prorated (reduced) gain exclusion—a percentage of the
$250,000 or $500,000 exclusion that might otherwise be available—in designated circumstances, as you are about to see.
The prorated gain exclusion equals the full $250,000 or $500,000 figure (whichever would otherwise apply) multiplied by a fraction.
The numerator is the shorter of:1
the aggregate period of time you owned and used the property as your principal residence during the five-year period ending on the sale date, or
the period between the last sale for which you claimed an exclusion and the sale date for the home currently being sold.
The denominator is two years, or the equivalent in months or days.2
When you qualify for the prorated exclusion, it might be big enough to shelter the entire gain from making a premature sale. But the prorated exclusion loophole is available only when your premature sale is due primarily to
a change in place of employment,
health reasons, or
specified unforeseen circumstances.
Example 1. You’re a married joint-filer. You’ve owned and used a home as your principal residence for 11 months. Assuming you qualify, your prorated joint gain exclusion is $229,167 ($500,000 × 11/24). Hopefully that will be enough to avoid any federal income tax hit from the sale.
Example 2. You’re unmarried. You sold your previous home 15 months ago and excluded the gain. Now you’re about to sell your current home, which you’ve owned and used as your principal residence for 21 months. You bought the current home and occupied it for six months before selling the previous home.
Assuming you qualify, your prorated gain exclusion is $156,250 ($250,000 × 15/24). Hopefully that will be enough to avoid any federal income tax hit from selling your current home.
The gain exclusion that you claimed on the sale of your previous home is completely unaffected by all this.
Premature Sale Due to Employment Change
Per IRS regulations, you’re eligible for the prorated gain exclusion privilege whenever a premature home sale is primarily due to a change in place of employment for any qualified individual. Qualified individual means the taxpayer (that would be you), the taxpayer’s spouse, any co-owner of the home, or any other person whose main residence is within the taxpayer’s household.3
A premature sale is automatically considered to be primarily due to a change in place of employment if any qualified individual passes the following distance test: the distance between the new place of employment/self-employment and the former residence (the property that is being sold) is at least 50 miles more than the distance between the former place of employment/self-employment and the former residence.
Example 3. You run your sole proprietorship business out of your home, which you’ve decided to sell after having owned and used it as your principal residence for only 19 months. You then buy a new home 65 miles away and run your business out of the new home.
According to these facts, you pass the 50-mile test because your new place of self-employment (the new house) is 65 miles farther away from your former home than was your old place of self-employment (the old house which was, obviously, zero miles away from itself).
Therefore, you qualify for a prorated gain exclusion. If you’re a married joint-filer, the prorated exclusion is $395,833 ($500,000 × 19/24). If you’re unmarried, the prorated exclusion is $197,917 ($250,000 × 19/24).
But note that you will be taxed on any gain attributable to depreciation from post-May 6, 1997, business or rental use of the home you sold, as explained later.
(But also note that on the business part of the home, you can use Section 1031 to defer and even avoid taxes.)
Example 4. Dante is married and files jointly with his wife, Clara. As an emergency room physician, Clara must live close to the hospital where she works, so the couple’s home is only three miles away. Now Clara becomes employed by a different hospital. As a result, they sell their home.
But they owned and used this home as their principal residence for only 22 months. Dante and Clara then rent a townhouse that’s only five miles away from her new job location. Assume her new job is 42 miles away from the old residence that was sold.
Dante and Clara fail the 50-mile test, because Clara’s new job is only 39 miles farther away from the old home than was her old job (42 miles versus 3 miles).
But again, due to the nature of Clara’s work, she must live close to her place of employment. Her facts and circumstances clearly show the premature sale of the former home was primarily due to a change in the place of Clara’s employment.
Consequently, Dante and Clara are eligible for a prorated gain exclusion of $458,333 ($500,000 × 22/24).4
Key point. If you can’t pass the 50-mile test, obtain documentation showing that the premature home sale was primarily due to a qualified individual’s change in place of employment, assuming the facts so indicate (as in this example). That should prove your eligibility for the prorated gain exclusion loophole if you ever get audited on the issue.
Premature Sale Due to Health Reasons
Per IRS regulations, you are also eligible for the prorated gain exclusion privilege whenever a premature sale is primarily due to health reasons. You pass this test if your move is to
obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or
obtain or provide medical or personal care for a qualified individual who suffers from a disease, an illness, or an injury.
For this purpose, qualified individual means
the taxpayer (that would be you),
the taxpayer’s spouse,
any co-owner of the home, or
any person whose principal residence is within the taxpayer’s household.
In addition, almost any close relative of a person listed above also counts as a qualified individual. And any descendant of the taxpayer’s grandparent (such as a first cousin) also counts as a qualified individual.5
A premature sale will automatically be considered primarily for health reasons whenever a doctor recommends a change of residence for reasons of a qualified individual’s health (meaning to obtain, provide, or facilitate care, as explained above). If you fail the automatic qualification, your facts and circumstances must indicate that the premature sale was primarily for reasons of a qualified individual’s health.
You cannot claim a prorated gain exclusion for a premature sale that is merely beneficial to the general health or well-being of a qualified individual.6
Key point. Whenever possible, obtain a doctor’s recommendation in writing to prove that you are entitled to the prorated gain exclusion because your premature sale was primarily for reasons of a qualified individual’s health. Keep the doctor’s note with your tax records.
Premature Sale Due to Other Unforeseen Circumstances
Per IRS regulations, a premature sale is generally considered to be due to unforeseen circumstances if the primary reason for the sale is the occurrence of an event that you could not have reasonably anticipated before purchasing and occupying the residence.
But a premature sale that is primarily due to a preference for a difference residence or an improvement in financial circumstances will not be considered due to unforeseen circumstances, unless the safe-harbor rule applies.7
Under the safe-harbor rule, a premature sale is deemed to be due to unforeseen circumstances if any of the following events occur during your ownership and use of the property as your principal residence:
Involuntary conversion of the residence.
A natural or man-made disaster or acts of war or terrorism resulting in a casualty to the residence.
Death of a qualified individual.
A qualified individual’s cessation of employment, making him or her eligible for unemployment compensation.
A qualified individual’s change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household.
A qualified individual’s divorce or legal separation under a decree of divorce or separate maintenance.
Multiple births resulting from a single pregnancy of a qualified individual.
For purposes of this safe-harbor rule, a qualifying individual is defined as (1) the taxpayer (again, that would be you), (2) the taxpayer’s spouse, (3) a co-owner of the residence in question, or (4) a person whose principal place of abode is in the same household as the taxpayer.8
Key point. If none of the preceding safe-harbor events occur, you can still qualify for a reduced gain exclusion if the facts and circumstances indicate the primary reason for your premature home sale was the occurrence of an event that you could not have reasonably anticipated before purchasing and occupying the residence.9
Premature Sales in Other Situations
If you cannot claim a prorated exclusion for a premature sale of your principal residence under any of the aforementioned specific rules, all is not necessarily lost.
You can still claim a prorated exclusion if, after considering all facts and circumstances, you can assert that the primary reason for your sale is deemed to be due to a change in place of employment, health issues, or unforeseen circumstances.
Factors that can help you make this claim as the primary reason for your premature sale include, but are not limited to, the following:10
Whether the premature sale and the circumstances giving rise to the sale are proximate in time
A material change in the suitability of the property as your principal residence
A material change in your financial ability to maintain the property
Whether you actually use the property as a residence during your ownership period
Whether the circumstances giving rise to the premature sale were reasonably foreseeable when you began using the property as a principal residence
Whether the circumstances giving rise to the premature sale actually occurred during the period when you owned and used the property as a principal residence
Claim Gain Exclusion for Home Used Partly for Business or Rental
Say you use the basement of your principal residence as a deductible home office or rent out that space during the entire time you own the home. Then you sell the home. The profit on the residential part of your home could qualify for the gain exclusion. The profit on the business or rental part seemingly could not, because it was not used for residential purposes.
Thankfully, IRS regulations allow you to treat the entire home as a single property if the residential part and the business or rental part are within the same dwelling unit.11 In that case, the entire property will qualify for the full $250,000 or $500,000 gain exclusion (whichever applies), as long as you meet the timing requirements for the residential part. Goooooood one guy!
Naturally, there’s an exception. You must include in your taxable income any gain up to the amount of depreciation deductions claimed for post-May 6, 1997, business or rental usage of the property.12
If the gain on the sale of the home is long-term, the depreciation on the office or rental is characterized as so-called un-recaptured Section 1250 gain that’s subject to a maximum federal income tax rate of 25 percent under current law. Since you’ve already reaped tax savings from the depreciation at your ordinary tax rate and possibly from self-employment taxes, this outcome is beneficial.
Example 5. You are a married joint-filer. You use part of your home as a deductible office for your real estate sales business during your entire ownership period. You’ve claimed $10,000 of depreciation deductions for the office space. You sell the home for a $500,000 profit, including $10,000 attributable to the depreciation write-offs.
Assuming you meet all the gain exclusion timing requirements for the residential part of your property, you can exclude $490,000 of gain. The remaining $10,000 is taxable un-recaptured Section 1250 gain from depreciation that’s subject to a federal rate of up to 25 percent.13
As the preceding two examples illustrate, you should be thoughtful about business or rental usage of space that’s not within the same dwelling unit as your principal residence (for clarity, think within the walls). Why? Such use could trigger a taxable gain that you cannot shelter with your gain exclusion privilege.
Example 6. The same basic facts apply as in the preceding example, except this time your office is in a detached building formerly used as a garage. You must treat the sale of your property as two separate transactions. Allocate the sales proceeds and tax basis between the detached building and the rest of the property, and calculate two separate gains. You cannot exclude the gain from selling the detached building.
Gain from the rest of the property (the part used as your principal residence) is eligible for the gain exclusion privilege, assuming you meet the timing requirements for that part of the property.14
Example 7. You converted the basement of your home into a separate rental dwelling unit by installing kitchen and bathroom facilities and a separate outside entrance. When you sell the property, you must treat the sale as two separate transactions.
Allocate the sales proceeds and tax basis between the basement and the rest of the property, and calculate two separate gains. You cannot exclude the gain from selling the basement.
Gain from the rest of the property (the part used as your principal residence) is eligible for the gain exclusion privilege, assuming you meet the timing requirements for that part of the property.15
Specifically, when the amount of gain allocable to the separate business or rental space would be considerable, you may want to avoid any business or rental usage during the two-year period preceding the sale date. That way, you will pass the two-out-of-five-years use test for the business or rental part of the property, and it will be eligible for the gain exclusion privilege.
And don’t forget the possibility of using a Section 1031 transaction on the portion of the property treated as a rental or a commercial office.
Premature Sale of Property Used for Business or Rental
What happens when you qualify for the prorated gain exclusion privilege upon a premature sale of a residence used partly for business or rental purposes? Good question.
Answer: calculate the prorated gain exclusion as explained earlier. Then use the prorated exclusion to shelter otherwise taxable gain, as explained in the immediately preceding discussion of homes used partly for business or rental purposes. You have three important things to remember here.
As explained earlier, the prorated exclusion deal is available only for a premature sale that’s primarily due to (a) a change in a qualified individual’s place of employment, (b) reasons related to a qualified individual’s health, or (c) unforeseen circumstances.
You cannot use the prorated home-sale exclusion to shelter gain attributable to any post- May 6, 1997, depreciation from business or rental use of the property.
When the business or rental part of the property is not within the walls of the same dwelling unit as the principal residence, the prorated exclusion can be used to shelter only gain allocable to the residential part of the property. Any profit on the separate business or rental part is fully taxable.
Example 8. You’re unmarried, and you use part of your home as a deductible office for your real estate sales business during your entire ownership period. You’ve claimed $2,000 of depreciation deductions for the office space, which is not in a separate structure. After owning the home for only 18 months, you sell it for a $150,000 gain, including $2,000 attributable to the depreciation deductions. Your premature sale is primarily for reasons related to your health.
You are entitled to a prorated gain exclusion of $187,500 ($250,000 × 18/24), which is more than you need in this case. You can shelter $148,000 of your gain ($150,000 - $2,000 from depreciation) with the prorated exclusion. The $2,000 that you can’t shelter is un-recaptured Section 1250 gain from depreciation that’s subject to a federal rate of up to 25 percent.16
Exclude Gain from Sale of Land Next to Your Residence
Per IRS regulations, you can potentially use the gain exclusion break to shelter profit from selling vacant land next to your principal residence. In fact, you can even sell the parcel with the home and the surrounding vacant land in completely separate transactions. Naturally, there are some ground rules (pun intended).
The vacant land must be sold within two years before or after the sale of the parcel containing the house. Separate sales of the parcel containing the house and the adjacent vacant land within this four-year window do not violate the anti-recycling rule.
The sale of the parcel containing the house must itself qualify for the gain exclusion.
The vacant land must be adjacent to the parcel containing the house.
The vacant land must have been owned and used as part of your principal residence, and the vacant land must pass the two-out-of-five-years ownership and use tests.
If you pass all these tests, you can use the gain exclusion privilege to avoid any federal income tax on gain of up to $250,000, or $500,000 if you’re a married joint-filer. Remember, here you are looking at the combined gains from selling the parcel containing the house and the adjacent vacant land. Understand that you get only one exclusion for the combined gains.17
For instance, an example in the IRS regulations says you could sell a one-acre parcel with your home in one transaction and a 29-acre adjacent parcel of vacant land in a separate transaction, and use the gain exclusion to shelter the combined profits from the two sales. Presumably, the same favorable result would apply if the vacant land were sold in several separate transactions.
What happens if you sell the adjacent vacant land in advance of the parcel containing your house? Good question.
If the parcel with the house is not sold until after the due date of your Form 1040 for the year of the land sale, you must report the gain from the land sale on your return for that year. Then, after you sell the parcel containing your principal residence, file an amended return to exclude some or all of the earlier land sale gain. You generally have three years from the date you file the original Form 1040 to file an amended return, assuming you filed the original Form 1040 on time.18
Takeaways
For home sellers, taking advantage of the federal income tax principal residence gain exclusion break can be a major tax-saver.
You must pass the ownership and use tests and avoid the anti-recycling rule to claim the maximum gain exclusion of $250,000, or $500,000 for married joint-filers. See Part 1 of our analysis for details on these restrictions.
In this article, you learned how to take advantage of the prorated gain exclusion loophole for a premature sale when that sale is primarily due to a qualified individual’s
change in place of employment,
health issues, or
specified unforeseen circumstances.
For this purpose, qualified individual means
the taxpayer (that would be you),
the taxpayer’s spouse,
any co-owner of the home, or
any person whose principal residence is within the taxpayer’s household.
You also learned that the home sale gain exclusion applies to the gain from the residence part, including the office part if it is within the walls of the residence (say, a bedroom). But depreciation of an office or a rental inside the home does not qualify for the gain exclusion and is subject to the un-recaptured Section 1250 tax rate of up to 25 percent.
And finally, you learned special rules that apply to vacant land that is considered part of your personal residence.
1 IRC Section 121(d)(1); Reg. Section 1.121-3(g).
2 Ibid.
3 Reg. Section 1.121-3(c).
4 IRS Reg. Section 1.121-3(c)(4), Example (4).
5 Reg. Section 1.121-3(f).
6 Reg. Section 1.121-3(d)(3), Example (5).
7 Reg. Sections 1.121-3(e)(1); 1.121-3(e)(4), Examples (7), (8), and (10).
8 Reg. Section 1.121-3(e)(2).
9 The regulations include three examples of non-safe-harbor situations that seem to indicate the IRS will be fairly liberal in this area. See Reg. Section 1.121-3(e)(4), Examples (4), (6), and (9). The IRS can also designate other events as unforeseen circumstances, in published guidance of general applicability (such as revenue rulings) or in rulings addressed to specific taxpayers (such as private letter rulings). But the guidance in the letter rule applies only to the specific taxpayers to whom the guidance is directed. See Reg. Section 1.121-3(e)(3).
10 Reg. Section 1.121-3(b).
11 Reg. Section 1.121-1(e).
12 Reg. Section 1.121-1(d).
13 Reg. Section 1.121-1(e)(4), Example (5).
14 Reg. Section 1.121-1(e)(4), Examples (1) and (3).
15 Ibid.
16 See Reg. Section 1.121-1(e)(4), Example (5) in conjunction with Reg. Section 1.121-3.
17 Reg. Section 1.121-1(b)(3).
18 Reg. Section 1.121-1(b)(3).
Sourced with the help of The Bradford Tax Institute.
Comentarios