Tax Consequences of Selling a Principal Residence

The year 2021 was an exceptionally good year for residential real estate sales across the United States. Many individuals sold their personal residences and made sizeable profits.

These individuals include federal employees and retirees living throughout the US. As they prepare their 2021 federal income tax returns, these individuals who sold their principal residences during 2021 need to consider these questions:

(1) What are the tax consequences resulting from the sale of their principal residences; and

(2) If required, how are the sales reported on their 2021 federal income tax returns?

This column presents a discussion on the tax consequences of selling a principal residence.

The tax rules associated with the sale of a principal residence are contained in Internal Revenue Code (IRC) Section 121. The sale of an individual’s principal residence is generally not reported on an individual’s tax return unless the individual:

(1) Incurs a capital gain resulting from the sale and does not qualify to exclude the capital gain (see below – under “Sale of Principal Residence – Capital Gains Tax Exclusion” ) from tax; or

(2) Receives a Form 1099-S (Proceeds from Real Estate Transactions) from the real estate settlement company or real estate attorney. A sample Form 1099-S is presented here:

In general, real estate agents, title companies, and real estate lawyers responsible for closing a residence sale transaction are required to issue Form 1099-S (a copy of which is sent to the IRS) to the seller of a real estate property. An exception applies for the sale of a principal residence in which the sales price $250,000 or less, or $500,000 or less for individuals filing as married filing joint or certain surviving spouses.

This non-issuance of a Form 1099-S occurs only if the real estate reporting person obtains written certification from the seller. The certification must include information to support the conclusion that the full gain on the sale is excludable from the seller’s income. If there are joint sellers, each seller, whether married or not, must make written certification for the exception to whether the reporting the sale via a Form 1099-S applies.

Sale of Principal Residence: Capital Gains Tax Exclusion

An individual is permitted to exclude from income up to $250,000 of capital gain resulting from the sale of a personal residence if the following tests are met:

• Ownership and use. The individual must have owned and used the home as a principal residence for at least two out of the five years ending on the date of the sale. The two years do not have to be consecutive.

• Frequency limitation. The exclusion applies to only one sale every two years.

Note the following:

(1) A home sale gain attributable to a period of nonqualified use cannot be excluded. A period of nonqualified use is any time after 2008 in which the property is not used as the individual’s principal residence; and

(2) Unmarried individuals who jointly own a principal residence may each exclude up to $250,000 of gain if the IRC Section 121 requirements are met.

Sale of a Principal Residence: Capital Gains Tax Exclusion for a Married Couple Filing Jointly

Married couples filing a joint return can exclude from income up to $500,000 of capital gain resulting from the sale of a principal residence under the following conditions:

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• Ownership. Either or both spouses must have owned the residence for at least two out of the five years prior to the sale.

• Use. Both spouses must have used the residence as their principal residence for at least two out of the five years ending on the date of the sale. Note that the two years do not have to be consecutive.

• Frequency limitation. During the two-year period ending on the date of the sale, neither spouse excluded capital gain resulting from the sale of another personal residence.

Note the following respect to married couples and the sale of their principal residence:

1. Use and frequency tests not met by both spouses. In order for a married couple to qualify for the full $500,000 exclusion, either spouse may meet the ownership test. But if both spouses do not meet the use and frequency limitation tests, then the allowable exclusion is limited to the sum of the amount that each spouse would be qualified to exclude if they had not been married. Each spouse is treated as owning the property for the period of time that either spouse owned the property. the following examples illustrate.

Example 1. On April 10, 2009, Robert purchased a home for $200,000. On June 15,2016 he married Amy who then moved into Robert’s home. Robert and Amy then sold their house on July 1,2021 for $700,000. Assuming they file a married filing joint 2021 federal income tax return, Robert and Amy can exclude from income the entire $500,000 of capital gain because Robert meets the two-year ownership test and both Robert and Amy meet the two-year use and frequency test.

Example 2. Sharon buys a home on July 1,2015 for $300,000. Sharon marries William on May 20,2021 at which time William moves in with Sharon. On August 26,2021 Sharon and William sell their home for $600,000 at a profit of $300,000. Sharon can exclude from income only $250,000 of capital gain even if they file a married filing joint tax return for 2021. This is because only Sharon meets the two-year use test.

Married Couple – Each Spouse Sells a Principal Residence

If both spouses own principal residences and each spouse meets the ownership, use, and frequency tests, then each spouse can exclude up to $250,000 of capital gain on the sale of his or her own home. The following example illustrates:

Example 3. On May 1, 2021, Dan and Delores got married and purchased a new home. Earlier in 2021 both Dan and Delores had sold principal residences they each had previously owned and lived in for more than two out of the last five years. Neither Dan nor Delores had excluded a principal residence capital gain in the prior two years. Dan had realized a capital gain on the sale of his principal residence of $210,000 while Delores had recognized a capital gain of $430,000 on the sale of her principal residence. Their capital gains total $210,000 plus $430,000 or $640,000. Their total capital gain exclusion is $460,000 ($210,000 for Dan and $250,000 for Delores). Dan may not exclude any of Delores’ excess capital gain of $430,000 less $250,000, or $180,000.

Surviving Spouse Sells a Principal Residence

The $500,000 capital gain exclusion amount that applies to individuals filing a married filing joint return also applies to unmarried surviving spouses if the sale occurs within two years of the death of their spouses. To qualify for the $500,000 exclusion:

(1) Either the surviving spouse or the deceased spouse must meet the two-year ownership requirement for the principal residence immediately before the spouse dies;

(2) Both spouses must meet the two-year use requirement immediately before the spouse dies; and

(3) Neither of the spouses may have used the exclusion during the past two years. The following example illustrates:

Example 4. Howard and Rachel are married and have owned their principal residence since Mar. 12,2012. On June 18,2021, Howard passes away and Rachel inherits his interest in the principal residence. Assuming Rachel does not remarry, and Rachel sells the principal residence before June 18, 2023, she will qualify for the $500,000 capital gain exclusion.

Note that the above rule for surviving spouses will not apply if the surviving spouse remarries before a sale or exchange of the residence within the two-year period.

Additional Information About the Use and Ownership Test

The following are some additional information about the use and ownership test:

• Use test. Qualifying use of a property as a principal residence may occur while an individual does not own the property. The following example illustrates:

Example 5. Casey, a single individual, lived in a home that she rented from 2014 through 2018 before she purchased the home on Jan. 1,2019. One month later on Feb. 1,2019, Casey moved out of the home and moved in with her sister. She rented out her house. While still living at her sister’s home, Casey sold her home on Feb. 28, 2021. The five-year period before the sale is Mar. 1,2016 through Feb. 28,2021.

• Ownership test. The ownership test requires that an individual own the principal directly, not through an entity. There are two exceptions: (1) A home owned by a single-member limited liability company (LLC) for tax purposes is treated as if the home is owned by the LLC member and therefore can qualify for the $250,000/$500,000 capital gain exclusion; and (2) An individual who is the grantor of a trust is considered to own a principal residence held in the grantor trust.

What Happens When There is More Than One Principal Residences?

When an individual alternates between two homes, the home that is used for a majority of the time during the year will be ordinarily be considered the principal residence, which is the only home that qualifies for capital gain exclusion. In addition to the individual’s personal use of the property, relevant factors in determining an individual’s principal residence include:

(1) the individual’s place of employment;

(2) the principal place of abode of the individual’s family;

(3) the address listed on the individual’s federal and state tax returns, driver’s license, automobile registration and voter registration card;

(4) the individual’s mailing address for bills and correspondence;

(5) the location of the individual’s banks; or (6) the location of religious organizations and recreational clubs with which the individual is affiliated.

Note that if an individual owns two principal residences at the same tie and occupied one home as a principal residence for years one and two, and then the other principal residence for years three and four, then either would be eligible for the $250,000/$500,000 capital gain exclusion if sold during years five or six. Both principal residences would qualify if the sales occurred more than two years apart and the two-out-of-five occupancy requirement is still met

Reporting the Sale of a Principal Residence

If the sale of a principal residence results in a capital gain that exceeds the excludable amount, then the seller must report the sales price and cost basis of the principal residence sold on IRS Form 8949 (Sales and Other Dispositions of Capital Assets) (Part I for a home owned a year or less or Part II for a home held owned more than one year; Part II for a home owned for more than one year) (see below). In addition, the application code is entered and the amount of any excludable gain is reported as a negative number. A fully excludable capital gain is reported on IRS Form 8949 only if the home seller received a Form 1099-S for the sale.

Note that a capital loss resulting from the sale of a principal residence is not reported, unless the home seller received a Form 1099-S in which case the sale is reported on IRS Form 8949 even though the capital loss is not deductible.