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CLE Course Outline: Exclusion Of Capital Gain On The Sale Of A Home

NAELA MemberThis outline by Attorney John L. Roberts are Part of a Continuing Legal Education Program Entitled: Everyday Tax Issues for Elder Law Attorneys presented on February 15, 2005. This outline is for information and education purposes only. It is not legal advice or opinion. Legal advice can only be provided to you by a competent professional who understands your unique circumstances.

 

For many people, the opportunity to exclude the gain on the sale of their principal residence is the biggest tax exclusion of their lifetime. We can help clients avoid mistakes and problems. §121 of the Internal Revenue Code is the source authority for this $250,000/$500,000 exclusion. Let's look at some typical situations that you'll see coming into your office:

Elder who owns and lives in the home now, and is selling:

This is the easiest situation to deal with. IRS Publication 523, Sale of Your Home (PDF) (HTML Format) explains the ownership and use tests that clients have to satisfy to exclude the gain on sale of their residence. Anyone who has handled a real estate purchase and sale has seen the IRS questionnaire form covering these tests at the closing:
Ownership test: During the 5 year period ending on the date of the sale you owned the home for at least 2 years;
Use Test: During that 5 year period, you lived in the home as your main home, and during the 2 year period ending on the date of the sale, you didn't exclude gain from sale of another home.
You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.

Page 12 of Pub 523 has an example:

Publication 523 example

In 1995, Helen Jones lived in a rented apartment. The apartment building was later changed to a condominium, and she bought her apartment on December 3, 2001. In 2002, Helen became ill and on April 14 of that year she moved to her daughter's home. On July 12, 2004, while still living in her daughter's home, she sold her apartment.
Helen can exclude gain on the sale of her apartment because she met the ownership and use tests. Her 5-year period is from July 13, 1999, to July 12, 2004, the date she sold the apartment. She owned her apartment from December 3, 2001, to July 12, 2004 (more than 2 years). She lived in the apartment from July 13, 1999 (the beginning of the 5-year period), to April 14, 2002 (more than 2 years).

The Use Test is less strict for elders who need care that can’t be provided in their residence. Special Rules in §121(d)(7) give a safe harbor to people who become incapable of self-care. If they own the property used as the principal residence during the 5-year period for periods aggregating at least 1 year, they are treated as using such property as their principal residence during any time during such 5-year period in which the taxpayer owns the property and resides in a licensed facility.

The regulations at 26 CFR Section 1.121-1(c) have more examples:

Section 1.121-1(c)(2)(ii): taxpayer has become physically or mentally incapable of self-care and the taxpayer sells or exchanges property that the taxpayer owned and used as the taxpayer's principal residence for periods aggregating at least 1 year during the 5-year period preceding the sale or exchange, the taxpayer is treated as using the property as the taxpayer's principal residence for any period of time during the 5-year period in which the taxpayer owns the property and resides in any facility (including a nursing home) licensed by a State or political subdivision to care for an individual in the taxpayer's condition.

Section 1.121-1(c)(3)(i) Trusts. If a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.

There are Safe Harbors, providing partial exclusion of gain, such as change in place of employment, health, or unforeseen circumstances. Pub 523 has worksheets and explanations. The IRS has also published a discussion of the rules.

The Elder Transferred the home to herself and other family members as Joint Owners (and it's too late to transfer full ownership interest back to the elder):

joint ownershipThis is often the situation for an elder had expected to remain in the home, but long term care became a necessity. Pub 523 explains the case when there are: "Joint owners not married. If you and a joint owner other than your spouse sell your jointly owned home, each of you must figure your own gain or loss according to your ownership interest in the home. Each of you applies the rules discussed in this publication on an individual basis."

 

 


Post Death Sale: The Elders Transferred the home to other family members, retaining a life estate for themselves, and the Elders are now deceased:

Normally a simple situation. §1014(b)(9) allows the Remainder People to receive the property at a stepped-up basis when the grantor dies. If is was personal use property by the elders, it continues to be personal use property in the hands of the children, unless they convert the property to income producing activity before the sale. If the property is personal use property when sold, any loss is nondeductible.

Prior to Death Sale: The Elder Transferred the home to other family members, retaining a life estate for the elder (and it's too late to transfer full ownership interest back to the elder in order to get the Principal Residence exclusion):

life estateThis situation comes up when the elder conveyed the home years ago, kept the life estate, and now can't continue living in the home. Is it possible to maintain the home or even rent the home until §1014(b)(9) allows the remainder people to receive the property at a stepped-up basis when the grantor dies?
If not, Pub 523 explains the "Sale of remainder interest. Subject to the other rules in this publication, you can choose to exclude gain from the sale of a remainder interest in your home. If you make this choice, you cannot choose to exclude gain from your sale of any other interest in the home that you sell separately.
Exception for sales to related persons. You cannot exclude gain from the sale of a remainder interest in your home to a related person. Related persons include your brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.) §121(d)(8)

The basis of the Life Tenant and Remainder People are established at the time of the creation of the life/remainder split, and remain frozen there. However, their relative ownership interests in proceeds of a sale for income-tax purposes, shifts over time as the Life Tenant ages. Their relative ownership interests are finally established on date of sale to the third party.

How do you figure out what the Remainder interest is worth on the date of sale to the third party? You start with the Applicable Federal Rate. §7520 says that this AFR will be120% of the mid term federal rate.

The AFR for January, 2005 (provided by the IRS in Table 5 of the revenue ruling for January) is 4.6%. The AFR is also available from tigertables.com or brentmark.com. We use this 4.6% rate to determine which Table to look at in the IRS Book Aleph (which is based on mortality tables published by the Department of Health and Human Services for 1989-1990.). IRS Bulletin Supplementing Table S for interest rates .2% - 2%

Using the 4.6% rate, let's look at an example: a married couple, and their remainder people, selling the elders' principal residence:

Table R(2) in Book Aleph says that .49071 is "the present worth of the remainder interest in $1.00 payable at death of the last to die of two persons" Ages 75 and 70. So, the life estate interest of H&W is .50929 [1.00 -.49071].

Let's say that in January, 2005 there was a $120,000 sale with $10,000 in closing costs. The gain on the sale is calculated as follows:

 

 

Life Interest
.50929

Remainder Interest
.49071
Sales Price

120,000

61,114.80

58,885.20

Less Expenses

-10,000

-5,092.90

-4,907.10

Amount Realized

110,000

56,021.90

53,978.10

Less Adjusted basis

-50,000

-25,464.50

-24,535.50

Gain on Sale

60,000

30,557.40

29,442.60

H&W's share of the gain would be $30,557.40. They can exclude this gain from income taxation because the house is their principal residence. The Remainder People would pay a capital gains tax on $29,442.60.

Another example: a single person and his Remainder People selling the elder's principal residence:

single life illustrationTable S shows the values for a Single life Age 75 at the 4.6% Interest Rate:

.36329 Life Estate value and .63671 Remainder value

 

If there is a $120,000 gain on the sale and $10,000 in sales costs, the Remainder People would pay a capital gains tax on their share of gain: $38,202.60:


 

 

Life Interest
.36329

Remainder Interest
.63671
Sales Price

120,000

43,594.80

76,405.20

Less Expenses

-10,000

-3,632.90

-6,367.10

Amount Realized

110,000

39,961.90

70,038.10

Less Adjusted basis

-50,000

-18,164.50

-31,835.50

Gain on Sale

60,000

21,797.40

38,202.60

If a Life Estate holder and the Remainder People do not sell their interests together, special special rules apply under §1001(e).

Can the loss of the full principal residence exclusion be cured by simply giving the property back to the elder, and getting a step up in basis when the elder dies? Maybe.
But be careful about deathbed conveyances. §1014(e) says that property that is transferred by a donor to a decedent within 1 year before the decedent's death, and then passes back to the donor will end up with the "the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent."
This is one of four exceptions the the step up in basis under Section 1014, which otherwise "steps-up" the basis of property in the hands of a person acquiring the property from a decedent to the fair market value of the property at the date of the decedent’s death. The other three exceptions are:

First: §1014(c): Property representing income in respect of a decedent- Section 691 - amounts of gross income the decedent was entitled to prior to death. Section (c) preserves the income element of amounts received after death, rather than giving them the status of property with a fair market value at death basis. The survivors who are taxed on this IRD are allowed a deduction for the federal estate tax attributable to the IRD.
Second: §1014(b)(9): Joint tenancy property to the extent the surviving joint tenant was not a contributor.
Third: §1014(9)
Depreciation that was taken by a surviving joint tenant to the extent he was not a contributor.

Beginning on January 1, 2010, an amendment to §121(d) will extend the principal residence exclusion to a home sold by:
(A) the estate of a decedent
(B) any individual who acquired such property from the decedent (within the meaning of section 1022), and
(C) a trust which, immediately before the death of the decedent, was a qualified revocable trust. The exclusion will be "determined by taking into account the ownership and use by the decedent."