"We contend that for a nation to try to tax itself into prosperity Is like a man standing in a bucket and trying to lift himself Up by the Handle"
Homeownership has long been the great American dream. Our tax laws have encouraged and indeed nurtured homeownership in three important ways: when you file your annual income tax return, you can deduct the interest you pay on your mortgage (up to a certain limit) ,and you can also deduct the real estate tax which you pay to your State and local governments. And when you sell your home, depending on the facts and circumstances, you can completely exclude a sizable portion of the profit you have made.
There remains uncertainty as to how (or even whether) Congress will make radical changes to our tax laws. But for now, the benefits remain and this column will address the tax benefits you can claim when you file your 2013 income tax returns. The IRS has announced that personal returns can now be filed beginning January 31st.
In order to qualify for these tax benefits, however, the home in which you live must be your legal, principal residence. And although some of these deductions are also available for investment properties, this column will address only your personal home.
There is no statutory definition for principal residence in the Tax Code. In fact, IRS Publication 17, entitled "Your Federal Income Tax, 2013", does not use those words, but instead calls it your "main home". If you ask an IRS agent -- or your tax attorney -- for a definition, 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."
What exactly does this mean?
There have been very few court cases in which principal residence has been defined, but in those cases, the courts provide 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." The IRS has a less complex response: it is "usually the home you live in most of the time".
But it does not have to be a single family property. Condominiums and cooperatives also qualify - assuming of course that you live there "most of the time". And a boat or a mobile home can qualify, if it has a kitchen, sleeping quarters and bathroom facilities - and of course you spend most of your time there.
But if you moved out of your house and have been renting it for some time, does that mean your home is no longer your principal residence? Not necessarily. You (and perhaps the IRS) will have to review the specific facts involving your particular situation, to make sure that you still qualify for the basic homeowner tax benefits. And it will also depend on which tax benefit you are trying to obtain.
For example, in order to qualify for the up to $250,000 exclusion of gain ($500,000 if you are married and file a joint tax return), you only have to live in the house two out of the past five years prior to it being sold. Thus, if you sold your house in December, 2013, you can still claim it as your principal residence for purposes of taking the exclusion, so long as you actually lived in the house for two years between December 2008 and the date of sale.
And the fact that you took a couple of weeks vacation during these two years does not change the situation. Short term or other seasonal absences are still considered as "use". The IRS provides the following example:
Professor Paul Beard, who is single, bought and moved into a house on August 28, 2001. He lived in it as his main home continuously until January 5, 2003, when he went abroad for a 1-year sabbatical leave. During part of the period of leave, the house was unoccupied, and during the rest of the period, he rented it. On January 6, 2004, he sold the house at a gain.
Because his leave was not a short temporary absence, he cannot include the period of leave to meet the 2-year use test. He cannot exclude any part of his gain, unless he qualifies for a reduced maximum exclusion (which is explained later).
Thus, once again, we see the interplay between "facts" and "circumstances". A short term vacation or business trip absence will still be considered as "use", but a one year sabbatical will not. But the IRS does concede that the ownership and use requirements do not have to be continuous. According to the IRS, "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..." 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."
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 Vermont 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.
Indeed, there are circumstances which would permit you to have two principal residences. For example, in 2008 and 2009, you lived in Washington, but in 2010 and 2011 you lived in Vermont. Each home will be considered your principal residence, but you can only claim the exclusion once every two years. Thus, if you sell the Washington property in 2012, and sell the Vermont property two years and one day after you have sold Washington, so long as you have owned and used each property for the requisite two out of five years before sale, you can take the exclusion on both properties for the year each was sold.
The operative words are "owned and used", which the IRS calls the "ownership and use tests". If you are married, you can claim the exclusion if: (1) either spouse meets the ownership requirement, (2) both spouses lived in the house as their main home for at least two years, and (3) neither spouse is ineligible because a previous exclusion was taken with the two year period ending on the date of the current sale.
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.
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, commonly known as a Starker exchange. Keep in mind that you can only exchange investment properties, not principal residences, and you will have to rent the property out for at least one year in order for it to be an investment. You must discuss this with your own legal counsel.
Thus, the question becomes: how important is the concept of "principal residence" under the 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".
If you have do not meet the use and occupancy requirements, you may still be eligible for the "reduced maximum exclusion". If the reason for selling your house was because of (1) a change in place of employment (i.e. the new job is at least 50 miles farther from your home), (2) health reasons, or (3) unforseen circumstances, you may still be eligible to exclude a portion of your gain. This requires some accounting skills in order to compute the amount of the exclusion you will be able to take. The reduced exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is 2 full years. If you are single -- or do not file a joint tax return -- change the $500,000 to $250,000.
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.
For a more comprehensive discussion, see IRS Publication 523, Selling Your Home, available free on the IRS Website, Click Here.