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What's Your Principal Residence? Tax Experts Not Always Certain

Written by on Sunday, 28 January 2001 6:00 pm
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American homeowners get two major tax benefits under our tax laws: they can deduct their mortgage interest and real estate tax payments while they own their house, and when it is sold, there are significant capital gains exclusions.

In order to qualify for these tax benefits, however, the home in which you live must be your legal, principal residence. And although these deductions are also available for investment properties, this column will address only your home.

There is no statutory definition for principal residence in the Tax Code. If you ask an IRS agent -- or your tax attorney -- for a definition, he or she will advise you that "whether or not property is used by the taxpayer as his principal residence . . . depends on all the facts and circumstances in each case, including the good faith of the taxpayer."

There have been very few court cases in which this concept has been defined, and in each opinion, the courts give the same answer: we will investigate the facts of each case, and make our decision based on those specific facts, on a case-by-case basis.

If you have lived in the same home for many years, and consider it to be your principal home, it will clearly be your "principal residence." The key elements which the Courts and the IRS consider include your voter's registration, where you pay local or state income taxes, and the address on your driver's license. However, if you moved out of your house and have been renting it for some time, you will have to review the specific facts involving your particular situation, to make sure that you still qualify for the basic homeowner tax benefits.

In its regulations, the IRS states that "the mere fact that property is, or has been, rented is not determinative that such property is not used by the taxpayer as his principal residence."

The IRS gives the following illustration: "if the taxpayer purchases his new residence before he sells his old residence, the fact that he temporarily rents out the new residence during the period before he vacates the old residence may not, in light of all of the facts and circumstances of the case, prevent the new residence from being considered as property used by the taxpayer as his principal residence."

The tax courts -- and now the law -- makes it very clear that a taxpayer is not required to actually occupy the old residence on the date of sale. The courts -- and the IRS -- will look at the particular facts and circumstances. More importantly, we have to look to the good faith of the taxpayer.

If the homeowner has two houses, and uses each as a residence for successive periods of time (such as alternating between Florida in the Winter and Washington during the rest of the year), the property that the homeowner uses a majority of the time during the year will usually be considered the principal residence.

And it is to be noted that a cooperative housing apartment, a house trailer or a houseboat will also be considered a "principal residence", so long as it contains a kitchen, sleeping quarters and bathroom facilities.

Real estate has been strong these past two years, and few homeowners found themselves in the situation where they had to rent their house because buyers were not available. But real estate is like a roller coaster; one never knows when the market will take a down-turn.

Regardless of whether you have to rent your house, however, keep in mind that to take advantage of the new tax saving laws, there are statutory time limits that have to be honored.

Under the Taxpayer Relief Act of l997, a married couple filing jointly can exclude up to $500,000 of profit (capital gain) so long as the house has been owned and used for an aggregate of at least two of the five years before the house is sold. An unmarried individual (or a person filing a separate tax return) can exclude up to $250,000 of gain. Neither the IRS nor the courts have the authority to extend this time.

The operative words are "owned and used". If you are married, so long as either spouse meets this requirement, the exclusion of gain applies. Marital status is determined on the date the house is sold. In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirement will include any time that the former spouse actually owned the property before the transfer to the other spouse.

The IRS has issued proposed regulations attempting to clarify the 1997 law. In these proposals, the IRS states:

The requirements of ownership and use for periods aggregating 2 years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 x 2).

The IRS then makes it clear that the ownership and use requirements do not have to be continuous. According to the proposed regulations, "the requirements ... may be satisfied during nonconcurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale..."

It should be noted that there are times when a homeowner wants to have the house considered as "investment" rather than principal residence. For example, if you have made a significant profit (i.e. more than $500,000) and are faced with a sizable capital gains tax, you may want to consider doing an exchange under Section 1031 of the Internal Revenue Code. Keep in mind that you can only exchange investment properties, not principal residences.

Thus, the question becomes: how important is the concept of "principal residence" under the new tax laws? The answer is that the exclusion will not apply unless the property is in fact your principal residence. Once this is determined, and if you meet the use and occupancy requirements, you should be eligible for the capital gains exclusion.

The burden of proof will be on you -- the homeowner -- to demonstrate that (1) this was your principal residence, and (2) you have, in fact, owned and used the house for two out of five years before it was sold.

How do you prove this?

  • Keep your driver's license which shows your former address;

  • Don't throw out utility bills which could demonstrate the period of time in which your were living in the house;

  • Keep your voter registration card which shows the old address.

All of these factors will play a role in determining the facts and circumstances of your particular case -- and the IRS will still apply the principal residence rules in determining "use and occupancy".

Here is an example from the IRS proposed regulations:

Taxpayer L owns two residences, one in Virginia and one in Maine. During 1999 and 2000, L lives in the Virginia residence.

During 2001 and 2002, L lives in the Maine residence. During 2003, L lives in the Virginia residence. L's principal residence during 1999, 2000 and 2003 is the Virginia residence. L's principal residence during 2001 and 2002 is the Maine residence.

Either residence would be eligible for the ($250,000-500,000) exclusion if it were sold during 2003.

There is an old adage that your home is your castle. Whether it will also be your principal residence will depend on how carefully you have preserved and documented all of the relevant facts.

(Next Week: "The Treatment Of Points")

Copyright 2001 Benny Kass. All Rights Reserved. Published by Realty Times (http://www.realtytimes.com ) with permission of the author.

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  About the author, Benny L. Kass

1 comment

  • Comment Link Margaret Monday, 07 October 2013 11:08 am posted by Margaret

    Are there any tax disadvantages to buying a potential principle residence in one tax year (2013) in another state and selling the former principle residence in another tax year (2014)? This scenario is based on buying a retirement home and once that is secured, selling the principle home in order to move full-time into the retirement home.

    Also, concerning capital gains tax benefits, can you rent your home for the last two of the five years and still received the 500,000/250,000 credit?

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