In the not so distant past, most property owners could sell their real estate and make a profit. Then some one turned off the music and ended the party. But while short-sales and foreclosures have become far common than profitable transactions, sellers who either acquired their properties prior to the end of the 2oth century or more recently acquired a distressed propertyat a discount may have significant capital gain when they sell.
In our last post, we detailed the several bites that government takes out of the capital gain apple upon the sale of real estate. With combined tax rates approaching 1/3 or more of the total gain, property owners can’t be blamed for having second thoughts about selling their properties.
The good news is that current tax law offers some relief. In certain circumstances, a taxpayer may be able sell their primary residence and exclude all or part of the capital gain from taxes. Additionally commercial property owners may be able to defer the capital gain from the sale of their asset if they acquire other “like-kind” property with the sales proceeds.
We’ll begin by discussing the rules that apply to the sale of a primary residence, and then discuss the relief available to commercial property owners in our next post:
Primary Residence Exclusion
Internal Revenue Code (IRC) Section 121 relates to the sale of a primary residence. It permits a married couple filing jointly to exclude up to $500,000 of capital gain from the sale and a single person to exclude up to $250,000 of capital gain, provided the house being sold was their principal residence for two of five years preceding the sale. For a married couple, this must be true for each spouse, though only one spouse needs to be on title to the property.
Additionally, the exclusion can only be taken once every two years, so you can’t play games by shifting your primary residence in the middle of the five years and then selling multiple properties at the same time.
In determining whether a home is the principal residence of the owner, the IRS will look at the owner’s place of employment, the amount of time they have used the property, where other family members live, the location of the owner’s bank, religious organizations and recreational clubs, as well as the address used for the owner’s tax return, driver’s license, car and voter registration, bills and correspondence.
A residence can include a houseboat, house trailer, and a cooperative apartment.
IRC 121 was enacted in 1997 and replaced IRC 1034, which permitted homeowners to roll-over their gain by buying a new primary residence within two years after their sale, and gave taxpayers age 55 and over a once in a life time exclusion of $125,000 of gain, provided the dwelling was their primary residence for three out of five years prior to the sale. So even if the provisions of IRC 1034 would be more beneficial to the homeowner, they no longer apply and can not be claimed.
Homeowners who have not lived in their residence for two years may be able to claim a partial exclusion in certain situations. Section 121(c) was clarified in 2002 under Treasury Decision 9030, permitting a homeowner to claim a partial exclusion when the primary reason for the sale is related to:
1. Health — a physician recommends a change in residence for health conditions affecting the owner or a family member;
2. Employment — if the owner’s new place of employment is at least 50 miles farther from the old home than the old place of employment;
3. Unforeseen Circumstances affecting the homeowner or a member of their household, including death, divorce, unemployment, certain negative changes in employment, multiple births from the same pregnancy, certain damage to the residence, and condemnation or other taking of the property.
Any gain in excess of the applicable exclusion will be taxed at the various rates discussed in our previous post. However, as we’ll discuss in a later post, it may be possible to take advantage of both the primary residence exclusion and the 1031 exchange in the same transaction, thereby avoiding paying any tax at the present time.
But first, we will discuss Section 1031 in general in our next post.
Brady Business & Real Estate Advisor 
Posted on 08/11/2011
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