The exclusion for gain on sale of your principal residence is widely known among tax practitioners and the public alike. The concept is fairly easy to grasp – if you live in your home for 2 of the last 5 years you can exclude up to $250k of gain on the sale or $500k if you’re married. Like anything else in the tax code, the devil is in the details. I dug into this topic a little deeper and found two things that may not be so well known about this exclusion.
Allocation of Gain to Non-qualified Use
This provision in §121(b)(5) was added as part of the Housing and Economic Recovery Act of 2008. Prior to its enactment, a taxpayer could have an appreciated rental property, move into the property for two years, sell it, and exclude the gain (except for prior depreciation). The non-qualified use provision stops this by requiring the allocation of gain to periods of non-qualified use.
In my example above, the taxpayer would be required to allocate 3/5 of the total gain to the 3-year period of non-qualified use. This means that 3/5 of the gain is taxable and 2/5 is not. The allocated gain is determined after subtracting out depreciationa. The portion of the gain resulting from prior depreciation is 100% taxable and the remainder is allocated 3/5 and 2/5 respectively.
Three exceptions are givenb, which are –
- Any portion of the 5-year testing period after the property was last used as a principal residence. This means that if a taxpayer converts a principal residence into a rental, they don’t have to allocate their gain on the sale to the period of time it was a rental. This is contrasted with a property that was a rental first and then converted to a principal residence.
- Any period of time during which the taxpayer or taxpayer’s spouse is serving on qualified extended duty
- Any other period of temporary absence not more than 2 years due to change in employment, health conditions or other unforeseen circumstances.
Treatment of Mixed-Use Properties
Not all properties are single-family homes. Some are duplexes, have basement apartments, and some are used in part as a home office. If the non-residential part (rental portion, home office, etc.) is a separate unit, the overall gain must be allocated to both units. The gain allocated to the non-residential unit is 100% taxable. If there is no separate unit (think renting a bedroom, using a room as a home office) then the overall gain does not need to be allocated between both units. The only taxable gain here, assuming all other requirements are met, is the prior depreciation.
Examples from the Regulationsc
Multiple Units – 3-story townhome with basement converted to an apartment with separate entrance, kitchen and bathroom
Single Unit – Using a room as a home office
If the taxpayer has two separate units, the gain is allocated in the same way that the basis was allocated to determine depreciationd.
c§1.121-1(e), Ex. 3 & 5