The exclusion of gain on the sale or exchange of a principal residence applies only to sale and exchange transactions and only to a property that is the taxpayer’s principal residence (Code Section 121(a); Regulation Section 1.121-1(a)).
Principal Residence: A property must be a residence of a taxpayer to qualify for the exclusion. If the taxpayer has more than one residence, the property must be the taxpayer’s principal residence to qualify.
The determination of whether a property is used by the taxpayer as a residence depends upon all the facts and circumstances. A residence can include a house, condominium, houseboat, house trailer, or a property the taxpayer is entitled to occupy as a tenant-stockholder in a cooperative housing corporation. However, a residence does not include personal property that is not a fixture under local law (Regulation Section 1.121-1(b)(1)). Thus, a recreational vehicle (RV) would not qualify as a principal residence for purposes of the exclusion-of-gain rule.
Additional Tax Tip:
However, as pointed out in Jackson v. Commissioner, 2017 PTC 11 (9th Circuit 2017), an RV can be a dwelling used as a personal residence for purposes of the rule in Code Section 280A that disallows any deduction relating to a personal residence.
If a taxpayer uses more than one property as a residence, the determination of whether a property is the taxpayer’s principal residence depends on all the facts and circumstances. If the taxpayer alternates between two or more properties, using each as a residence for successive periods of time, the property he uses as a residence for a majority of the time during the year is generally treated as his principal residence. However, the taxpayer’s use of a property is not necessarily conclusive on this issue. Other relevant factors that must be taken into account include, but are not limited to:
(1) the taxpayer’s place of employment;
(2) the primary place where the taxpayer’s family members live;
(3) the taxpayer’s address for purposes of federal and state tax returns, driver’s license, auto registration, and voter registration;
(4) the location of the taxpayer’s banks; and
(5) the location of religious organizations and recreational clubs with which the taxpayer is affiliated (Regulation Section 1.121-1(b)(2); Revenue Ruling 77-298; Friedman v. Commissioner, Tax Court Memo. 1982-178; Evans v. Commissioner, Tax Court Memo. 1962-61).
Example: Joey Bagofdonuts owns two residences, one in Virginia and one in California. From 2011 through 2017, Joey lives in Virginia seven months of each year and in California five months of each year. Absent other facts and circumstances, the Virginia residence is Joey’s principal residence. He is eligible for the exclusion on a sale of the Virginia residence, but not the California residence.
The sale or exchange of vacant land can be treated as part of the sale or exchange of a principal residen1ce, but only if:
(1) the vacant land is adjacent to land containing the dwelling unit of the taxpayer’s principal residence;
(2) the taxpayer owns and uses the vacant land as part of his principal residence;
(3) the taxpayer sells or exchanges the dwelling unit in a transaction that qualifies for the exclusion within two years before or after the sale or exchange of the vacant land; and
(4) the sale or exchange of the vacant land would otherwise qualify for the exclusion (Regulation Section 1.121-1(b)(3); Revenue Ruling 56-420; Hughes v. Commissioner, 450 Federal 2d 980 (4th Circuit 1971); O’Barr v. Commissioner, 44 Tax Court 501 (1965)).
Sale or Exchange: The exclusion applies only to a sale or exchange of a taxpayer’s principal residence. No statutory definition is provided for the terms “sale” and “exchange.” Therefore, the common and ordinary meanings of those terms apply for Federal income tax purposes. A sale generally is a transfer of property for a fixed or determinable sum of money or its equivalent that the buyer pays or promises to pay to the seller. An exchange generally is a reciprocal transfer of property between two taxpayers (Regulation Section 1.1002-1(d); Commissioner v. Brown, 380 U.S. 563 (1965); Runyan v. U.S., 281 Federal 2d 590 (5th Circuit 1960); Frank Lyon Co. v. U.S., 435 U.S. 561 (1978)).
An involuntary conversion of a principal residence is treated as a sale of the principal residence for purposes of the exclusion. Thus, the exclusion applies to an involuntary conversion of a principal residence. If a taxpayer buys a new principal residence as a result of an involuntary conversion, the ownership and use periods of the old principal residence will be tacked to the ownership and use periods of the new principal residence for purposes of determining the exclusion when that residence is sold or exchanged (Code Section 121(d)(4); Regulation Section 1.121-4(d)). See Tax Tip Involuntary Conversions.
Additional Tax Tip:
Any amount excluded under these rules reduces the amount realized for purposes of applying the involuntary conversion rules.
However, the exclusion does not apply to the sale or exchange of a principal residence if the taxpayer acquired the principal residence in a like-kind exchange during the 5-year period before the sale or exchange of the principal residence (Code Section 121(d)(10)). See Tax Tips for for a discussion of like-kind exchanges.
The exclusion generally applies to gain from the sale or exchange of a partial interest in a taxpayer’s principal residence. A partial interest is any interest in the principal residence that is less than the entire interest in that residence. The tax treatment of a partial interest depends on whether the partial interest is a remainder interest or another type of interest.
The exclusion applies to a partial interest other than remainder interest as long as the partial interest sold or exchanged includes an interest in the taxpayer’s dwelling unit of the principal residence. The sales or exchanges of two or more partial interests in the same principal residence are treated as one sale or exchange and only one $250,000 limitation ($500,000 for certain joint returns) applies. For purposes of the rule that limits the exclusion to one sale or exchange every two years (see Tax Tips discussion of the exclusion test), each sale or exchange of a partial interest in a principal residence is disregarded with respect to other sales or exchanges of partial interests in the same principal residence (Regulation Section 1.121-4(e)(1)).
The exclusion applies to a remainder interest only if the taxpayer makes an election to have it apply to that interest. If the taxpayer makes such an election, the exclusion will not apply to a separate sale or exchange of any other interest in the principal residence. A taxpayer makes the election by not including the gain from the sale or exchange of the remainder interest in gross income on his tax return for the year of the sale or exchange. This election may be made or revoked any time during the three-year period after the due date (excluding extensions) for filing the tax return for that year (Regulation Section 1.121-4(e)(2)).
The exclusion applies to certain payments received due to the foreclosure of the taxpayer’s principal residence. In Revenue Ruling 2014-2, the IRS ruled that a taxpayer who receives an National Mortgage Settlement (NMS) payment resulting from the foreclosure of the taxpayer’s principal residence, must include the payment in income under Code Section 1001 as an amount realized on the foreclosure. If a taxpayer includes the payment in the amount realized and, as a result, creates or increases a gain on the foreclosure of the principal residence, the taxpayer may exclude the resulting gain from gross income to the extent permitted under Code Section 121. In addition, because an NMS payment is intended to compensate a borrower for loss of a principal residence rather than for loss on other property, if a taxpayer receives an NMS payment for loss of a multiple-unit property, a portion of which was used as the taxpayer’s principal residence, then the entire NMS payment is allocable to the portion of the property used as a principal residence. A taxpayer that receives a deceased eligible borrower’s NMS payment “stands in the shoes” of the borrower for purposes of determining the tax consequences of that payment. Any gain not excluded from gross income under Code Section 121 is income in respect of a decedent.
In Fiscalini v. Commissioner, Tax Court Memo. 2017-163, the Tax Court held that an individual’s sale of a personal residence to his parents, in which he discharged two mortgages but received no cash or other property, was a sale in part and a gift in part. The individual had originally purchased the home with his parents and they subsequently transferred their interest in the home to him as a gift. The amount realized by the individual on the sale to his parents was the amount of the liabilities discharged, and his gain was determined by subtracting from that amount his basis and settlement costs and excluding $250,000 of the gain under Code Section 121.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
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Palm Desert, CA 92260
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(Updated 03/10/2021 02:15)