Understanding the Capital Gain Tax Rules When Selling a Primary Personal Residence

A previous column discussed the capital gain exclusion rules with respect to the sale of a primary personal residence. In that column, it was mentioned that if the requirements are met an individual can exclude up to $250,000 of capital gain (profit) from the sale of a principal residence and a married couple filing jointly can exclude up to $500,000 of capital gain (profit) from the sale of their principal residence.

Real estate sales during 2022 decreased compared to sales in previous years. For those federal employees and retirees who may have sold their principal residence during 2022, it is important to review the IRS rules contained in Internal Revenue Code Section 121 regarding the sale of a principal residence.

What is a Primary or Principal Personal Residence?

A primary or principal personal residence must be an individual’s main residence and may include a: (1) house; (2) houseboat; (3) mobile home; (4) cooperative apartment or condominium; and (5) it does not have to be located in the United States (IRS Revenue Ruling 54-611).

Vacant land is not considered part of a main home unless the vacant land is:

(1) Adjacent to the land containing the home, and

(2) used as part of the main home, such as for recreation.

If these two rules are met then the sale of the land and the sale of the home are treated as one sale.

More Than One Home

Only the sale of the main home qualifies for the $250,000/$500,000 capital gain exclusion. Any other home sale is taxable. It is not possible to have two principal residences at the same time as the following examples illustrate.

Example 1. Aliza owns a home in Rockville, MD. She also owns a condominium in West Palm Beach, FL. which she uses during the winter months. The house in Rockville, MD is Aliza’s main home.

Example 2. Burton owns a home in Rockville, MD but he actually lives in Fort Lauderdale in a home he rents. The home in Ft. Lauderdale is Burton’s main home and the home in Rockville MD would not qualify for the capital gain exclusion.

Individuals who live in more than one home use the simple rule of where they lived for the most time. In some situations, other factors may be involved such as: (1) Place of employment; (2) Location of family members main home; (3) Mailing address; (4) Legal address for tax returns, driver’s license, voter registration, etc.; (5) Banking location; and (6) Location of clubs and houses of worship to which the individual belongs.

Determining Gain or Loss Upon the Sale of a Principal Residence

The formula to calculate the gain or loss upon the sale of principal residence is:

Note 1: The selling price does not include personal property such as furniture.
Note 2: The selling price does include mortgages or notes assumed by the buyer.
Note 3. Payments from employers to reimburse for a loss on a home sale are included on Form W-2 and should not be included as part of the selling price.
Note 4: Form 1099-S (see below) is used to repot the sales price. Problems involving Form 1099-S include: (1) The form does not include loan assumption or services rendered, and (2) the form may not be issued if the lender believes the entire sales price amount is excludable.

Note 5: Transfers to spouse as a result of a divorce are not taxable or reportable.
Note 6: Selling expenses include a number of items such as reprinted below from CFS Tax Tools (www.taxtools.com) software.

Note 7: Cost basis in a home is adjusted for a number of factors as reprinted below from CFS Tax Tools (www.taxtools.com) software.
Purchase price, plus closing costs. If the seller paid points at close, reduce basis in the home if bought after 4/3/94.

Note 8: Losses on the sale of a principal residence are not deductible and cannot be applied against capital gain.
Note 9: on a married filing separate return, each spouse’s gain or loss is calculated, and the applicable rules are applied separately, according to ownership interest.
Note 10: In the case of a principal residence owned by unmarried individuals, each gain or loss is calculated and the applicable rules applied separately to ownership interest.

Calculating the Excluded Capital Gain (Profit) Resulting from the Sale of a Principal Residence.

Three general rules apply to an individual’s excluding the capital gain (profit) from the sale of a principal residences. They are:

• The ownership-test. The individual must have owned the residence for at least two years out of five years ending on the sale date.

• The use-test. The individual must have used the principal residences (lived there) for at least two years out of five years ending on the sale date; and

• The exclusion-test. The capital gain exclusion cannot be used more than once every two years.

The maximum amount of capital gain exclusion is $250,000 per individual. Note that in order to use the $250,000 capital gain exclusion, there is no requirement for the individual to purchase a more expensive principal residence. The capital gain exclusion can be sued more than once during an individual’s lifetime but not more than once every two years.

A married couple filing joint tax returns have a maximum capital exclusion of $500,000 and can be used if the following requirements are met:

• Either spouse must meet the ownership test, and

• Both spouses must meet the use test (see above), and

• Neither spouse has excluded a capital gain exclusion resulting from the sale of a principal residence in the last two years.

Capital Gain Exclusion Resulting from the Sale of a Principal Residence Owned by a Surviving Spouse

In the Mortgage Forgiveness Debt Relief Act of 2007, effective with tax years beginning on or after January 1, 2008, gain on the sale of a personal residence that had been jointly owned by a surviving spouse and a deceased spouse will qualify for the full $500,000 capital gain exclusion. This is only true if the sale closes no later than two (2) years after the date of death of the deceased spouse. Previously, the full exclusion was only available if the home was sold during the year that the spouse died. Note the following:

Understanding the Capital Gain Tax Rules When Selling a Primary Personal Residence

• Either spouse may meet the ownership but both spouses must meet the use test for this rule

• If the surviving spouse remarried before two years has passed, the exclusion amount reverts back to $250,000, and

• Personal residences owned separately by the survivor rather than jointly with the deceased will also qualify for this special treatment.