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Selling Your Residence? Plan to Maximize Your Tax Exemption

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Planning to downsize? Helping a parent sell the family homestead? The Internal Revenue Code permits gains from the sale of a principal residence to be realized tax-free, subject to relatively generous limits, as long as certain requirements are met. Here are a few pertinent points:

1. The Basic Rule

If a couple (or either spouse) owns real property used by the couple as their principal residence for two of the five years ending on the date of sale, $500,000 of the gain on sale ($250,000 for an individual) will be exempt from capital gains taxes. Ownership and use periods need not be concurrent. For example, a couple who rented their residence for two years before buying it and sold it a year later would qualify for the exemption. Purchase of a replacement residence is not necessary in order to qualify for the exclusion.

2. The Nursing-Home Exception

Time residing in a licensed care facility is credited toward the two-year residence requirement.

3. The Survivorship Exception

Sale of a couple’s residence within the two years following the death of one spouse will qualify for the full $500,000 exemption, assuming that other requirements are met.

4. Trust Ownership Issues

Ownership of the residence by a revocable trust will not affect eligibility for the exemption. But if the grantor of the trust dies and the trust becomes irrevocable, the exemption, including the survivorship exception discussed above, will no longer be available to the extent that the property is owned by the irrevocable trust. This may not make a difference in most circumstances, since the tax basis of the residence would increase to the fair market value at the grantor’s death. But loss of the exemption could result in some taxable gain if, for instance, a sale were delayed so that a surviving spouse could continue to live there, and the property increased in value in the meanwhile. In any event, the possible loss of the exemption should be considered in allocating assets to bypass or credit shelter trusts following the death of one spouse.

5. How About the Second Home?

The home that a taxpayer uses as a residence for a majority of the year is normally considered his or her principal residence. But other factors, such as voting registration, driver’s license, motor vehicle registration, and address used for income tax returns, can enter into the determination.

6. Is the Lot Next Door Eligible?

The exemption can apply to sales of vacant land adjacent to a residence if the ownership requirement is met, the land was used as part of the residence (e.g., as a playground for the kids), and the land was sold within two years of the sale of the residence.

7. What if I Rent Out the Spare Room Through Airbnb?

Use of space in a residence for business or rental purposes can result in partial loss of the exemption. There would be no loss of exemption if (a) the space was not being used for business or rental at the time of sale; (b) there was no business or rental income from the space in the year of sale; and (c) the space was used for the taxpayer’s residential purposes for two of the five years preceding sale. Recapture of depreciation that you may have previously deducted from income would still be necessary, however, because the exemption applies only to capital gains, not ordinary income items.

As these examples demonstrate, application of the exemption is a simple matter in a straightforward situation such as sale of a couple’s long-term residence. But other circumstances can mean that the exemption does not apply, or applies only partially, and require careful consideration when a property used as a residence at any time is sold.