There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Tax law provides some tax benefits for homeowners. There's the property tax deduction the mortgage interest deduction. There's energy credits which we talked about in an earlier episode. There's basis adjustments for certain improvements, uh, to [00:00:30] your home. If you make those improvements, that increases your basis. And when you sell it later, you get to reduce the gain by, uh, that increased basis. If you run a business out of your home, you can qualify for the home office deduction, uh, for that business use. There's also the basis step up to fair market value on the date of the owner's death. So if a homeowner dies, someone inherits that house, they get to step up the basis to whatever the fair market value. So if they turn around [00:01:00] and sell it, then it's a lot less gain for them, a lot less tax to have to pay on that gain. And then there's one particular benefit that I want to talk about in this episode, and that is the capital gain exclusion from the sale of the taxpayer's principal residence. There's actually a lot of nuance to this, and I've seen some situations where either the rule is described in terms that are a lot more simplistic than it really is, or where [00:01:30] I've seen tax returns where the sale wasn't correctly reported from this. So that's the topic for this episode. Like I said, I mentioned energy credits. That's episode one of this show. So if you haven't heard that episode, go back and listen to that.
Jeremy Wells: Uh, and then in an earlier episode, I also discussed section 1031 exchanges. Personal residences don't qualify for section 1031 exchanges only investment property that is meant to for rental [00:02:00] purposes. So those qualify for section 1031 exchanges, but not personal residences. However, there is this special provision in tax law for selling your principal primary personal residence. So I'm going to talk about that on this episode. In the meantime. Uh, if you're listening, what say I appreciate you please show some love. Uh, and support for this show. Go leave a rating and a review, especially if [00:02:30] you're listening to this in Apple Podcasts. It'd be a great way to spread the love for the show and to put this podcast in front of listeners who could really use the benefits of listening to these discussions. So home sales are a massive component of the US economy. As of mid 2025, the median existing home price in the US is around $400,000 and about 3 to 4 million existing homes are sold nationwide [00:03:00] each month. That's that's a lot of money moving through the economy based on home sales. And for a lot of taxpayers, selling a home is probably the largest financial transaction they'll make in their entire lives. So it's incredibly important that we understand the tax implications of what selling a home looks like. And to sort of frame this episode, I want to look at a relatively recent tax court case where it shows how things can go wrong if we don't really understand [00:03:30] the rules.
Jeremy Wells: This is the case of Stephen and Catherine Webert. This is Webert versus commissioner Tax Court Memorandum 20 2232. So Stephen and Catherine Webert, they got married in 2004. Unfortunately, in 2005, just after purchasing a home, Catherine, uh, was diagnosed with cancer. So they got married in less than a year. Later, she bought a house for them. She was diagnosed with cancer. They [00:04:00] had the house. They took out a line of credit on the house in order to pay the medical bills resulting from the surgeries and the treatment she needed for the cancer. In 2009, so about four years later, she attempted to sell the house. Now, if you were alive, uh, in 2008, 2009, you remember what was happening then? That was the Great Recession. The housing market in the US collapsed. She wanted to sell the house for funds, to pay off the debt [00:04:30] and to pay for her medical expenses. However, that economic situation made selling the house impossible. So instead, after trying to put it on the market for a few months, they ended up renting it out. So they rented the house from 2010 to 2015, and then they finally were able to sell the house in 2015. Now, when they sold the house in 2015, this married couple filed a joint federal tax return, and they excluded the gain from the sale of that house.
Jeremy Wells: There was a pretty significant [00:05:00] six figure gain from selling that house. The IRS pulled the return for examination, issued a notice of deficiency, basically saying that they did not, uh, agree that that gain should have been excluded, and instead they wanted to see that gain reported as capital gain income. The taxpayers, uh, when they got that notice of deficiency, they timely they correctly followed the procedure and they filed a petition in the tax court [00:05:30] because, uh, they believe that they should be able to exclude that gain. Now we're going to talk about some of the details in this case and explain why the IRS was correct in this case and that they were not allowed to exclude that game. But we're going to talk about how to make sure that you and your clients don't find themselves in a similar situation. So first of all, let's talk about what we mean by this concept of principal residence. What is your principal residence for purposes of being able [00:06:00] to exclude the gain from the sale here? Well, first of all, let's talk about the structure itself. What do we mean by a residence? A lot of times in tax law we'll use the term residence or we'll use the term dwelling unit. Dwelling unit comes up a lot, especially when we're talking about rental properties. And it will come up a little bit here in this discussion about, uh, excluding the gain from your principal residence as well.
Jeremy Wells: But in this particular part of tax law, which pretty much all stems from section [00:06:30] 121 of the Internal Revenue Code, we are told that a residence can include a house, condominium, houseboat or mobile home, or other similar fixed types of dwelling units that comes from Treasury Regulation section 121 One B1. So this is the definition of a resident. Now whether it's your principal residence or not, we're going to talk about in a minute. But for [00:07:00] now, in order for it to be a residence, it needs to be that fixed dwelling unit. Personal property that is not a fixture under state law does not count. And this essentially means recreational vehicles. Sometimes recreational vehicles do count as these sort of dwelling units. In fact, there are there's a lot of discussion about how rental, uh, tax law applies to recreational vehicles, how the how to correctly report rental revenue from RVs, that [00:07:30] sort of thing. In this case, we're just going to go ahead and say that those can't count as a residence and therefore they can't be considered a principal residence. So even if you and your immediate family live in a recreational vehicle, you're driving it around the country. That's not going to be your principal residence for purposes of taking advantage of this exclusion of the gain from selling it. You're more than welcome to do that.
Jeremy Wells: I have I know some people who have done that. In fact, I've got a colleague of mine, another [00:08:00] very successful tax professional who spent a couple of years with his family driving an RV around the country, and that that was their home, uh, for that period. They they shared a lot of pictures. They had a lot of fun on that trip. Unfortunately, that RV is not their principal residence, uh, for purposes of this part of the code section. Now, what about vacant land? Vacant land, obviously is not going to be your principal residence. You need some sort of structure to live in. But [00:08:30] the vacant land selling a portion of the property that a residence is on, if you're selling just a portion of that, that is vacant land that could potentially qualify as part of a sale of a of a principal residence, as long as it's adjacent to the land of the taxpayer's principal residence, that it was used as part of that principal residence, and that the taxpayer ends up selling the actual dwelling unit, the structure, [00:09:00] within two years, either before or after the sale of that land. So this is trying to take into account the fact that sometimes we don't sell an entire piece of land with a dwelling unit on it all in one transaction. We might have a taxpayer who wants to subdivide that land or wants to sell different parcels of it out separately.
Jeremy Wells: Maybe it's a relatively large piece of land, and more houses could be built on some of the different parcels. I've even had cases [00:09:30] where parents own a homestead with a relatively large piece of land around it, and they want to turn that into parcels, sell that to their children, and let their children's families build houses on those parcels. So these are all different ways that we might need to think about taking into account whether this property, the sale of this property, actually qualifies as the sale of a principal residence. It is possible to sell a piece of vacant land, as long as it's attached to [00:10:00] the land that actually has that principal residence on it, but then also the actual principal residence itself. That dwelling unit needs to be sold within two years, either before or after. Now, if that happens, then the sale of the land and the residence and the rest of the land, the rest of the property that that all sits on, that's all treated as a single sale. So there might be a question, for example, if that piece of vacant land was sold first and [00:10:30] then there's a two year window there. So what happens if that vacant land is sold one year? The actual principal residence is sold the following year. You might have a bit of an awkward reporting situation there. You might have to look at carrying over the sale of that vacant land for at least a year.
Jeremy Wells: To go along with the dwelling unit, you might have to make some decisions about how you want to report that for the year of the sale of the vacant land, but that is possible, [00:11:00] uh, in to sell some of that subdivided or parceled out vacant land. Now, whether that residence is actually the principal residence or not depends on the particular facts and circumstances of that particular taxpayer. Some people own multiple homes. They might own a house in the town that they usually live and work in. They might own a vacation home. They might own a second home somewhere. They might own two different [00:11:30] homes and spend roughly half the year in each of them. Could be a lot of different situations where it isn't exactly evident which one of those properties is really the principal residence. And at that point, you might be in a position where you just have to make a call and discuss that with the taxpayer as to which property really is the principal residence. So whether a property is a principal residence or not depends on those facts and circumstances, especially if the taxpayer alternates [00:12:00] between two or more properties, then the property used the majority of the time is usually considered the principal residence. But again, you might have a case where they spend six months in one property, six months in the other property. So then we've got to look at some important factors.
Jeremy Wells: And Treasury regulation 1.2 11B2 lists some of these out. Now it's not an all inclusive, exhaustive list here. There might be other factors that you come upon that matter as well. But in order to get you started [00:12:30] thinking about being able to choose which of these properties is really the principal residence, the regulation gives us a few options. So we're going to look at the taxpayer's place of employment. Where does the taxpayer actually work? Again, this might not be that helpful in the age of remote work, of virtual work. It's entirely possible that there isn't a physical location that that person works at, or that person works from home, and home is wherever that person just happens to be during that stretch of [00:13:00] the year. Now, another criterion here to look at is where immediate family members live. So if the taxpayer if the individual is moving back and forth between these locations, but the rest of their family tends to stay at one or the other location, that might indicate which of those is the actual principal residence. Another one is mailing addresses for bills and correspondence. Now, both residences are probably going to get bills, but you could look at other things that aren't [00:13:30] particularly tied to the specific property. So maybe look at where their financial records and financial correspondence is getting sent to, where are they getting their bank statements sent to? Where are they getting their credit card statements and bills sent to? Those sorts of things.
Jeremy Wells: Uh, that might be an indication of which of those that taxpayer considers to be the principal residence. Where is the taxpayer's religious organizations, recreational clubs, social events? Where do they tend to go to for those things? [00:14:00] And then also, what's the address that the taxpayer uses on federal and state documents such as tax returns, driver's licenses, automobile registrations, voter registrations? All of these sorts of things can help clue you in to where that taxpayer really considers home. Now, the taxpayer that I've had to have some of these conversations before it can feel a little awkward. You might feel like you're investigating that taxpayer a little bit when you don't really mean to. However, you know, [00:14:30] we want to make sure that we can substantiate and back up this claim that the sale of this property really is the the taxpayer's principal residence, especially when it's going to be difficult to just point to where that taxpayer spent most of the year because it's really split between two or more different properties. So the more information we can gather and document from the taxpayer showing a preference toward one or the other of these properties, the better off we'll be. So let's go back [00:15:00] and think about the, uh, the tax court case with the Weber tier. So the couple used the home that the that the spouse Catherine bought as their principal residence.
Jeremy Wells: Both spouses lived there. They used it as their principal residence from 2005 to about 2010. Now, starting in 2010, they rented it out and they moved into another home that the, uh, that the husband Steven, uh, had owned before they got married. They [00:15:30] never used that house as a as a personal residence again. It was a rental right up until they sold it. So there is a period here where that home qualified as their principal residence from 2005 to 2010. However, there's definitely a period after that where it's not a their principal residence and it's really not even their own residence. They own it, but they never use it as a residence again after they converted it to a rental in 2010. So now how much can we actually exclude? [00:16:00] So the maximum gain exclusion under section 121 is $250,000. That comes from IRC 121 B1. The maximum gain exclusion is 250,000 unless and then this is a big exception. This is one of those exceptions in tax law, where married couples filing jointly have a significant advantage over all other kinds of taxpayers, and that is that they get double [00:16:30] the exclusion. So the exclusion, that maximum exclusion amount is actually Hundred thousand dollars for a married couple filing jointly if they qualify. And I'll talk more about that qualification here in a minute. That's IRC 121 B2 A now non-qualifying spouses. Again, I'll talk about what actually qualifies for a married couple filing jointly here in a little bit.
Jeremy Wells: But even if they don't qualify for that joint double exclusion of $500,000, [00:17:00] they might still separately qualify. Even if they file a joint return, they might individually qualify for that base maximum exclusion of $250,000 each. However, the exclusion allowed would be the sum of the exclusions allowable had they not been married. So this might be kind of a weird situation. I haven't run into this yet where this would make sense, but if we looked at a married couple [00:17:30] and they did not qualify for the $500,000 exclusion, it might still be possible that individually they each would qualify. For some exclusion, and in that case, we would sum their two exclusions up to $250,000 each. A married couple filing separately can each exclude $250,000 of the gain that's attributable to each spouse's interest in the property. [00:18:00] This is a situation that I've run into just just a handful of times. Uh, and in general, it still tends to work out, uh, very similarly to if they'd been filing jointly. However, there are some situations where it could, uh, wind up to where there would be a limitation where they could not, uh, get that full $250,000 exclusion. But this is actually in Treasury Regulation 121 to 82. So what you would do in [00:18:30] this case is figure out how much of this house does each spouse in this couple actually own? Of the house.
Jeremy Wells: Now think back to this tax court case. Remember that one spouse, Catherine, actually bought the house. We're going to talk about the ownership and use tests here in a minute. But in terms of the ownership test, if Stephen and Catherine were not married, that house would have been Catherine's. They did not own that house together. Only [00:19:00] one spouse's name was on the deed there. There are, however, some rules around how we treat ownership and use when we're dealing with a married couple, though. So in this particular case, it wouldn't have mattered for them. But there might be a case where you've got a married couple filing separately, and you would need to ascertain how much each spouse's interest in that house actually is. Now, for an unmarried widow or widower, [00:19:30] That individual may be able to use the joint exclusion, but the key here is that the widow or widower is still unmarried. So an unmarried widow or widower will still qualify for the $500,000 exclusion if the couple would have qualified and that widow or widower sells the property within two years of the date of death of the of the deceased spouse. That's [00:20:00] important to keep in mind. The sale needs to happen within two years of the date of death. In order to qualify for that full joint double $500,000 exclusion. The unmarried widow or widowers period of ownership and use includes the deceased spouse, periods of ownership and use, and I'll talk more about those ownership and use tests here in a little bit.
Jeremy Wells: So in other words, if you've got a married couple that have owned [00:20:30] a home together for, let's just say, five years. One of them, uh, dies. Then it's as if the surviving spouse, uh, owned that property the entire five years as well, too, that also, uh, tax in the case of a divorced spouse. So a spouse receiving, uh, property transferred from a spouse or as part of a divorce, uh, includes all that time [00:21:00] that they, uh, owned and used the property, uh, together, uh, to the transferring spouse. So the if a married couple, it goes through a divorce and the home exchanges, uh, ownership from one of the spouses to the other, then the ownership and the use from the transferring spouse carries over to the to the spouse that winds up owning the property. So [00:21:30] let's go back and think about the tax court case here. The Weber tier. So as a married couple they filed a joint income tax return for the year of the sale 2015. They filed jointly. So in this case their maximum exclusion would be the full $500,000 in that case. So any gain on the sale of that home that they calculate up to $500,000 [00:22:00] could be excludable if they qualify. And that's a big if in their case. Uh, if you're paying attention, you might have already caught on to some of the, uh, reasons that they may not qualify, but I'll discuss those here, uh, in a little bit more.
Jeremy Wells: Uh, so now the ownership and use, which I've already hit on, uh, a little bit here, uh, qualifying for the owner for the exclusion requires that the taxpayer pass [00:22:30] three different tests. The ownership test, the use test, and the prior exclusion test. Unless there is some exception, which I'll discuss here in a little bit, but the taxpayer has to pass those three tests in order to qualify for the exclusion. The use test, the ownership test, and the no prior exclusion test. Now, the taxpayer may need to adjust the maximum [00:23:00] exclusion for some of those exceptions and other considerations, which I'll get into in a minute. But in general, in order to qualify for that maximum exclusion, that taxpayer has to pass all three of these tests. Now the ownership and the use test are, uh, discussed together in IRC section 121 a uh, in fact, it's one sentence, uh, that in order to qualify for the exclusion, the taxpayer must own [00:23:30] and use the property as a principal residence for at least two years of the five year period immediately preceding the sale. This is often referred to as the two out of five year rule. In general, in order to be able to exclude the gain from the sale of principal residence, the taxpayers have to own and use both own and use the property as a principal residence for two of the last [00:24:00] five years immediately preceding the sale.
Jeremy Wells: Now it's can get a little bit more nuanced than that. So first of all, starting off looking at married couples, married couples both have to pass the use test. They if they're filing a joint return for the year of the sale or exchange, they qualify for that Hundred thousand dollars. That double exclusion if either spouse owns the home, but both [00:24:30] spouses used it as a principal residence for two of the last five years, and neither spouse is ineligible for the exclusion. We'll talk about some reasons why that might happen. So it's important to note here that only one spouse has to pass the ownership test. And this makes sense. Again think about our tax court case. One spouse uh, in in that case, uh, Katherine Weber. She actually purchased the home. So the home was in her name. And this would be true in with a lot of [00:25:00] married couples, predominantly, uh, the the man, uh, in a, uh, in a heterosexual couple would be the one who usually, uh, manage the finances, whose name was listed as the owner of a lot of the major assets. Right. So typically, that's the way you're going to see this reported. But, uh, even in modern couples, you're going to see that perhaps one spouse in that relationship is the quote unquote breadwinner. And so that [00:25:30] spouse tends to make the majority of the income and maybe have his or her name on the ownership papers for all the major assets that they own.
Jeremy Wells: In that case, you're probably going to have one spouse that actually owns, on paper, that asset, the home in this case, whereas really both spouses together are using that home as their principal residence. So that's why the law is written in such a way that you can have [00:26:00] either or both spouses owning the property, but both of them have to use it as their principal residence. Uh, and then also added to that, neither spouse is ineligible for the exclusion. So it's important to keep track of that. When we're looking at these cases with married couples, it's fine if only one spouse owns the property, but we need to make sure and verify that both spouses have actually used that property as their principal residence. You [00:26:30] might have a situation where you've got a married couple that don't live together. I know of married couples, and even though it's definitely not common behavior for married couples, it's entirely possible that you have a married couple that they they live in separate houses. That could be for a variety of situations. Uh, they might have gotten married, each owning their separate home, and wanted to keep living that way. They might live in separate locations for work related reasons. There could be, uh, good, legitimate reasons that they own separate [00:27:00] homes.
Jeremy Wells: And so even though they're married, they don't both use the same principal residence. And so in that case, they may not qualify for the, uh, $500,000 exclusion. They may only qualify for a $250,000 dollar exclusion when one or the other sells their home. It's also important to note that the usage does not have to be concurrent. So [00:27:30] when we say that the married couple has to both use that property as their principal residence for two of the last five years, it doesn't have to be the same two years for both spouses. It's entirely possible that one spouse uses it for a different two year period out of the last five years before the sale, than the other spouse, as long as they have each used that property for [00:28:00] at least two of the last five years. Then they both used it for two of the last five years. It doesn't have to be concurrent. There can be some overlap there, or it could be two completely separate two year periods. The taxpayer satisfies That ownership and use test. If she owns and uses the property for an aggregate of 24 months or 730 days within the five year period [00:28:30] ending on the date of the sale or the transfer. And this is just another way of of saying what I just did, but about a married couple. But it also applies to an individual as well. So when we're looking at usage, even though initially, uh, at the at the start of the code section, that's phrased in terms of two of the last five years, later on, uh, in the Treasury regulations, this is uh, section 1.1211 C1.
Jeremy Wells: We actually get [00:29:00] a definition of what we mean by two years, and it's not two full years. It's actually either. And we have the choice here. We can either measure that in terms of 24 months, or we can measure that in terms of 730 days. It's entirely possible that we look at the last five years before that sale, and we're going down to the level of individual days and counting the number of days that that [00:29:30] individual use that property as a primary residence in order to get to 730 days or two years. Um, and it just needs to add up to 730 days or 24 months. It doesn't need to be a sequential period, a single block that lasts two years, a single block of time. In fact, short periods of absence, such as vacations or even seasonal absences are still counted [00:30:00] as periods of use of that primary residence. So back to the example where you've got a taxpayer who maybe owns a vacation home, a second home, and say that they like to go spend their winters in that vacation home that's down at the beach, Even that what might seem like a relatively extended absence of. You know, a couple of months even that is technically still use of that first home as a principal residence.
Jeremy Wells: And then definitely [00:30:30] if they go on a 2 or 3 week vacation, that sort of thing, that's definitely going to be continued use. So we don't have to, within that five year period, worry about when they took vacations or even when they spent, uh, an entire season at a second home. That all still counts. However, we are able to look more granularly at the at the the time period within that five year block of in order to come up with two years of usage of that property as principal residence. [00:31:00] When we're dealing with older, uh, taxpayers, we need to think about how this might affect the the counting of that usage of their principal residence. So taxpayers who are moved into assisted living might qualify as well. So a taxpayer incapable of self care that moves into a licensed facility, such as a nursing home, may still qualify for the exclusion if [00:31:30] she owned and used that property as a principal residence for periods aggregating at least one year during the five year period preceding the sale or exchange. So this is important to note as well. If you have an aging taxpayer who's moved into a nursing facility or an assisted care facility, then it's, uh, and that, uh, period, uh, resulted in that taxpayer not living the full two [00:32:00] of the last five years in that principal residence.
Jeremy Wells: That individual might still qualify for the exclusion if we have a period of at least one year of the last five years living in that home as a principal residence. And then we wind up with some interesting cases where taxpayers might do some weird things with the ownership of their home. This is definitely one of those things that floats around on social media, where you get someone recommending that people move their [00:32:30] homes into their personal residences into an LLC for some purported tax benefit, which most of the time doesn't really exist. So in those cases, it's possible that an individual claims that their LLC, their limited liability company, now owns their principal residence, and this might cause some problems in in various [00:33:00] ways. However, there is an exception here in the regulations for section 121 that allows a taxpayer who owns a principal residence through either a trust or a disregarded entity to treat that property as if the taxpayer still owns it. And if the taxpayer sells the property through that trust or LLC, then it's still treated as if the taxpayer sold that property. So there was a time where I would have been [00:33:30] confused by that. If a taxpayer if a if a client had told me that she, uh, put her personal residence into her LLC, I might have been inclined to think that, well, you just caused problems for yourself with section 121 because you don't own your home anymore.
Jeremy Wells: Your LLC owns your home. Uh, but there is this exception here in the Treasury regulations that ownership via a disregarded entity or a particular kind of trust means that, uh, we're still for purposes of [00:34:00] the section 121 exclusion, we're still going to treat that principal residence as if it's owned and sold by the taxpayer. But it's important to note that that limited liability company owned by an individual, or in some cases by a married couple as community property and then elected to treat it as a disregarded entity, is a disregarded entity. Otherwise, you might have an issue. So, for example, if it's a married couple that does not live in a community property state. Well, [00:34:30] now if they put their personal residence in an LLC, that LLC is not disregarded for tax purposes. So they they may actually have created an issue for themselves there. So if you have a taxpayer tell you we put our our personal residence into an LLC, you need to ask more questions. Uh, who owns the LLC? And, you know, it's up to you whether you want to ask why they did this or not. Sometimes I do, sometimes I don't, but, uh, [00:35:00] you know, motives don't matter. What matters here is, uh, whether this, uh, is still going to And to qualify for the exclusion. And if it's a single member, LLC or a LLC owned by two spouses that that own that LLC and that property is community property, then they might be in the clear.
Jeremy Wells: The third rule that I mentioned before, that's a lot on the ownership and use test. And really those are the two that we tend to focus on the most. But then there is this third rule [00:35:30] that we need to be mindful of that can cause problems as well. And this is the once every two year rule. So a taxpayer can can get that exclusion only once every two years. So taxpayer does not qualify for the exemption if she applied it to a sale within two years prior to the sale. So if the taxpayer bought a home, sold [00:36:00] it excluded any of the gain from the sale of that home, bought another home and then within two years of the sale of the first home, sold the second home. Then that taxpayer is not going to be eligible to get that exclusion of the gain again on the second home. Now, there are some exceptions to this, and I'll talk about those exceptions that could generate some partial exclusions [00:36:30] here in a minute. But this is especially important when we think about individuals who might be, uh, or even couples who might be selling secondary residences. They might own a second home. They sell one or the other of those two homes, and then relatively quickly, they want to turn around and sell the other one also.
Jeremy Wells: Uh, I recently, uh, worked through this with a client that was retiring, and they [00:37:00] owned a their principal residence near where they worked. And then they also had a vacation home that that they they did not have any rental activity or anything. It was also their personal residence. Uh, but they had their principal residence, and then they had the second home as well, and they wanted to retire in the area of that second residence. So they sold the principal residence where they worked right when they retired. And then they moved [00:37:30] into the vacation home. Well, the vacation home was one bedroom condo on the third floor of a building. And being a retirement age, they didn't want to have to climb stairs. And there was no elevator in this building. So they very quickly started looking for something different to move into for their retirement. And they wanted to immediately turn around and sell this vacation home as well. And luckily they told me about their plans [00:38:00] before they got too far into it so I could explain to them that they would probably have an issue doing that, because I knew the exceptions that I'm going to discuss here in a minute, and I knew they wouldn't apply to them because of the way they had done this, and so they would have an issue with this once every two years rule. So what I ended up convincing them to do was to hold off, uh, and they, you know, they assessed what the housing [00:38:30] market was going to look like, uh, both in terms of being able to find a new property and in terms of being able to sell their condo.
Jeremy Wells: And they decided that, uh, it was the right thing to do for them, uh, in order to stay put until they could get that, uh, exclusion, because they had owned that vacation property for quite a while, and it was in an area where the housing market had had, uh, significantly increased, housing prices significantly increased. So we were looking at quite a bit of potential [00:39:00] gain when they sold that vacation property, and we knew that that was something they were going to want to avoid. So that's that can create some good tax planning opportunities to really provide some value to your clients. Of course, you've got to be lucky. And that taxpayer actually explain to you what their plans are before they get too deep into them, before you can't do anything about it. Now there's a concept built into section 121 here that can [00:39:30] that can get a little confusing. And I've seen it trip up tax professionals before. And this is the concept of non-qualified use. So gain during periods of non-qualified use cannot be excluded. So what do we mean by non-qualified use. So a period of non-qualified use means any period during which the property was not used as a principal residence of the taxpayer or the taxpayer, spouse or former spouse.
Jeremy Wells: Remember the [00:40:00] use for married couples and even divorced couples includes use by the other spouse, so a period of non-qualified use means any period during that period during which the property was not used as a principal residence. But and this is where I see tax professionals get tripped up, it does not include any portion of the five year period after the last date, the taxpayer or spouse used the property [00:40:30] as the principal residence. So what do we mean by that? Typically, what we're looking at here is a residence that was a principal residence, and then it was converted to being a rental. And then we're going to look at whether the taxpayer qualifies to exclude the gain when they sell that property. And the important question here is did that resonance, uh, [00:41:00] get converted to a rental and then get sold, or was it converted to a rental? And then did the taxpayer move back into it and use it again as a principal residence and then sell it? And that can be important. That can be critical when it comes to thinking about this period of non-qualified use. Because remember, it does not include any portion of that five year period after [00:41:30] the last date, the taxpayer or spouse used the property as the principal residence. If the property was a principal residence and then converted to a rental and then sold, and the taxpayer never moved back into it as a principal residence, then that period of rental is not non-qualified.
Jeremy Wells: Use. According to the definition in IRC section 121 B5. So we've got to be very important. We've got to be very careful. And [00:42:00] it's very important that we look at what the actual use of that property was before it was sold within that five year period, especially if it was converted to a rental. Now, also, non-qualified use does not include up to a ten year period of serving on qualified official extended duty. I'll talk about that exception here in a minute. Uh, or any other period of temporary absence due to a change of employment, health conditions or unforeseen circumstances. [00:42:30] And this is where we start to get into the partial exclusion that I'll talk about in a minute here. Uh, depreciation recapture and nonresidential use also, uh, don't qualify. So the exclusion does not apply to depreciation recapture. If that property is converted to a rental and then sold, even if there is some period of use there as a principal residence within that five year period that would qualify for the exclusion. We cannot use [00:43:00] that exclusion against the depreciation recapture for the period that it was a rental. And then also, if that property was partly used as a principal residence and partly for nonresidential purposes. And this is thinking about a home office. Uh, the taxpayer has to allocate the gain to the residential and the nonresidential portions of the property, and then only the gain from the residential portion can be excluded [00:43:30] under section 121.
Jeremy Wells: And the taxpayer has used the same allocation method that she used to determine that depreciable portion of the property. That basically means if you use the square footage of the home to determine the Home Office percentage, in order to calculate those home office deductions, then you need to use that method to calculate Eight. The portion of the gain that you can exclude. There's also another method that [00:44:00] uses the rooms in the the structure, the home, in order to calculate the home office deduction. That one doesn't get used as much, but it is there. Uh, if if you use that method to calculate the home office deduction, you would need to use that same method, uh, in order to calculate the portion that the gain that the exclusion of the gain can apply to versus cannot apply to. And then as I said, there is this ten year extension, uh, or an extension [00:44:30] to ten years, uh, for certain personnel. And these are members of the armed forces, Foreign Service and the intelligence community, and they get an extension of five additional years. So up to ten years, uh, for that window during which we're, we're seeing if, uh, the taxpayer can exclude that gain. And this is, uh, IRC section 121 D9. If you're in one of those three fields armed Forces, Foreign Service, or the intelligence community, [00:45:00] then you can use a ten year window during which to see if you've got that two years of use and ownership in order to be able to exclude the gain.
Jeremy Wells: This is essentially trying to account for the fact that people in these lines of work are typically stationed abroad for quite a long period of time, might be more than five years, and so they get an extra five year window during which to account for that. Back [00:45:30] to our tax court case with the Webots. This is where they start to run into trouble. So the Webots own the property for ten years before they sold it. So they definitely met the ownership test. But the use test is where they have a problem. They used it as a principal residence for four years. So normally if it were just two years that of use, they would have been fine. However, for five years preceding the sale, they did not use the property as their principal [00:46:00] residence. They converted it into a rental in 2010 and then sold it in 2015. Now we have to look back five years from when they sold it. And so that takes us to 2010. That entire five year period, it was a rental. They never used it as their principal residence during that five year window. And it's on this point that that they're going to run into trouble as far as the, uh, the exclusion goes.
Jeremy Wells: And this is pretty much where the [00:46:30] tax court is going to wind up. But there's a little bit of a complication here. So I mentioned partial exclusions. Certain taxpayers may qualify for a partial exclusion if that change in residence is due to a change in place of employment, Health or unforeseen circumstances, and the sale would not otherwise qualify under either the two year ownership and use rules, uh, or [00:47:00] the one sale every two years, uh rule. So if there's an issue with either of those, uh, with any of those three rules, then the taxpayer may be able to qualify for a partial exclusion, and it would equal the taxpayer's normal maximum exclusion amount. So $250,000, unless it's a married couple filing jointly. And in that case, it's $500,000 multiplied by the ratio of the shorter of the time periods of those three [00:47:30] rules. So you've got to look at those three rules. And what's the shortest of the time period of those three rules. And then count that in terms of either months or days, and then divide that by either 24 months or 730 days. And so then you'll get that ratio and it'll be some number between 0 and 1. One and you will multiply that by that maximum exclusion. So they'll get some partial exclusion out of that. So the taxpayer can take the partial exclusion [00:48:00] if she qualifies under a safe harbor, or in case one of those safe harbors isn't met under facts and circumstances, that the of the sale that indicate that it was necessary due to a change in place of employment, health or unforeseen circumstances.
Jeremy Wells: So some important factors to look at here are the time between the sale or exchange and the circumstances necessitating that sale or exchange that those circumstances weren't reasonably foreseeable. Um, [00:48:30] and then, uh, a material change in the suitability of that property as a principal residence or the taxpayer's financial ability to maintain that property that might also qualify or help that taxpayer qualify for a partial exclusion. There are three safe harbors I want to cover here. And for each of those three exceptions change in place of employment, health, and then unforeseen circumstances. For each of those, there's a safe harbor associated [00:49:00] with that exception. So the first one is the distant safe harbor for a change in employment location. If the taxpayer moves at least 50 miles farther from the former principal residence. Um, if the if the taxpayer's job moves at least 50 miles farther, then that automatically qualifies under the distant safe harbor. And in this case, self-employment also counts as employment. So if you've got a taxpayer that's running their own business and they move [00:49:30] their business more than 50 miles away from that, uh, principal residence, and they need to move also, then that would qualify under this distant safe harbor.
Jeremy Wells: The second safe harbor is the physician's recommendation for medical issues, and this goes along with that exception for health issues. Now here are the taxpayer qualifies for a partial exclusion. If a physician recommends a move [00:50:00] in order to obtain, provide or facilitate the diagnosis, cure, mitigation or treatment of disease, illness or injury, or to obtain or provide medical or personal care for the taxpayer, the taxpayer's spouse, a co-owner of that property, or certain dependents, uh, suffering from a disease, illness, or injury. So there's actually relatively wide latitude here in terms of what would qualify under this physician's [00:50:30] recommendation. But it's important to note that a sale that's merely beneficial to the general health or well-being of an individual does not qualify. This, uh, comes up a lot, especially with older taxpayers, when they want to move to a warmer, drier climate such as the southwest, just because they might expect to have a little bit easier time in [00:51:00] terms of their health or well-being due to that change in climate that will not qualify for this partial exclusion. There needs to be a physician's recommendation, and that recommendation needs to be tied to an actual diagnosis, cure, mitigation or treatment of some actual disease, illness or injury in order to qualify. And then there's a specific event, safe harbor, where the taxpayer would qualify for a partial [00:51:30] exclusion if that sale or exchange resulted from unforeseen circumstances and just a mere preference for a different residence or an improvement in financial circumstances doesn't qualify.
Jeremy Wells: So just moving because you think you can, uh, get a better, higher paying job, or you think cost of living will be less moving somewhere else that doesn't qualify. And, uh, just deciding that you don't like where you live and want to live somewhere different, [00:52:00] that also doesn't qualify as an unforeseen circumstance. But here are some exceptions that explicitly do qualify for these unforeseen circumstances that are listed out here in Treasury Regulation 1.2 11E an involuntary conversion. I'm going to have a future episode talking about involuntary conversions. Uh, but this is essentially going to happen as a result of a casualty, uh, loss. So a big storm, natural disaster, uh, that sort of thing. And a natural disaster is another exception here. Acts [00:52:30] of war or terrorism, uh, death of the taxpayer, the taxpayer's spouse, a co-owner or certain dependents. A change or cessation of employment that results in an inability to pay housing or living costs. So if you're actually, uh, you know, demoted at work or fired or laid off and you need to move somewhere less expensive to live, that will qualify as one of these unforeseen circumstances, uh, divorce or legal separation. [00:53:00] And and this is a big one. Multiple births from the same pregnancy. If you have a taxpayer that is surprised to find out that they're expecting, uh, twins, triplets, quadruplets, whatever, and they say they need to upgrade the house because they won't have enough space for all those new children.
Jeremy Wells: That is not going to qualify for a partial exclusion if they don't pass all three of the ownership use and, uh, once every [00:53:30] two year test. So back to the tax court case. Steven Weber, the the husband in this couple. He wanted to argue. He tried to argue before the Tax court that they deserved a partial exclusion due to his wife's health problems due to her cancer diagnosis. But the court clarified in this case that although that makes general sense, tax law is not always fair. And what the law [00:54:00] here for this exclusion says is not that you get a partial exclusion if you qualify for one of these reasons, but rather that's only if you fail to meet the ownership use. And once every two year rule, it does not extend the five year period. The only way you get an extension there is to work in the armed forces, foreign service or intelligence community. That's the only way you're going to get that extra [00:54:30] five years. Otherwise, we're all stuck with that same five year window preceding the sale of the home. And so even though they did have this health issue, and that's ultimately why they sold in the five year period leading up to that sale, they never used that property as a principal residence, and therefore they didn't qualify for the maximum exclusion or any partial exclusion either.
Jeremy Wells: So there is no exception to that five year time [00:55:00] period. Even if you qualify under one of these other exceptions, that's only for the ownership use or once every two year rule. So ultimately, the court held that the Webers were not entitled to any exclusion of the gain from the sale of their home. So to wrap up here, it's incredibly important that we fully understand all of the nuances of the rules when it comes to excluding the gain and sale of the home. Again, like I started off saying, this [00:55:30] could be one of the most significant, if not the most significant financial transactions that a client of yours or that a taxpayer is involved in in their life. We want to make sure we get this right. So it's important that we understand those three tests the ownership test, the use test, and the once every two years test. And then it's really important that we understand those exceptions to those three tests as well. But ultimately it all depends on that five year period. We have to look at that five year period. [00:56:00] We have to account for if there was any, uh, non-qualified use within that five year period. And then we have to look within that five year period to see if they meet those three tests. So that is how we handle the sale of a principal residence. Again, make sure you understand these rules and you correctly apply them to your taxpayer situations.