File Memorandum

Date:              8/5/2015 2:42:00 PM

By:                  David Glenn

Client:            John and Jane Doe

Re:                  Exclusion of Gain on Sale of Principal Residence

Facts:

1.  John Doe and his wife Jane purchased their principal residence in July of 1997 for $200k.

2.  The property contains two units, Units 1 and 2. John Doe and his family lived in Unit 1 from July 1997 to April 2012.  Unit 2 was rented or made available to rent to college students continuously July 1997 until April 2012.

3.  In April of 2012, John and Jane Doe moved into Unit 2 and rented Unit 1 to college students through May of 2014

4.  In May of 2014, John Doe’s son and his son’s family moved into Unit 1 while John and Jane Doe continued living in Unit 2.

5.  While living in Unit 1, John Doe’s son paid $900/month to John Doe for help with the housing costs. John Doe did not receive payments from his son for every month and there was no formal rental agreement.

6.  While the Doe’s son was living in Unit 1, the Does use of Unit 1 consisted of –

  • Use of the laundry facilities
  • Payment of utilities
  • Spent a lot of time with family
  • Use of Unit 1’s address for tax filings, bill mailings, and all other purposes.

7.  John Doe’s son and his son’s family moved out of Unit 1 in June of 2015. The Does remained in Unit 2.

8.  In 2003, Unit 1 and 2 were legally made into or recognized as two separate units. Under local law it’s called a duplex.  Nothing about the structure changed, just the legal status.

9.  Unit 1 has a separate address from Unit 2. Unit 2’s address is the same as Unit 1 except that it includes and “A” on the end.

10.  John Doe is a college professor and wants to retire at the end of the next school year in May of 2016.

11.  In August of 2015, the Does sell their property for $900k. Since purchasing the property, they’ve made $200k of improvements that increase the property’s basis.

12.  The allowable amount of depreciation was taken on Unit 1 and 2 while they were rented or made available for rent.

Issues:

1.  How much of the gain on the sale of the property will be taxable?

2.  How much of the gain on the sale of the property will not be taxable?

3.  What will the character of the taxable gain be?

Analysis:

1.  §121(a) and (b) provides an exclusion of up to $500k of gain on the sale of a married couple’s principal residence. To meet this requirement, the taxpayers must own and use the property as their principal residence for period aggregating 2 years out of the 5-year period preceding the sale.

2.  §121(b)(5) provides that gain allocated to periods of non-qualified use is taxable

  • §121(b)(5)(C)(i) provides that non-qualified use means any period the property is not used as the principal residence of the taxpayer
  • §121(b)(5)(C)(ii) provides exceptions to non-qualified use, which are –
    • Any portion of the 5-year period before the sale of the property which is after the last date the property is used as the taxpayers’ principal residence
    • Any period during which the taxpayer or taxpayer’s spouse is serving on qualified official extended duty
    • Any other period of temporary absence, not more than 2 years, due to change of employment, health conditions, or other unforeseen circumstances

3.  §121(c) provides for a pro-rated exclusion amount if a taxpayer fails to meet the ownership and use tests. The pro-rated exclusion amount is calculated by dividing the total time the property is used as a principal residence by 2.  This quotient is then multiplied by the applicable exclusion amount, $250k per taxpayer.

  • 121(c)(2)(B) provides that this pro-rated exclusion amount only applies to sale or exchanges due to changes in place of employment, health, or unforeseen circumstances.
  • 1.121-3(c)(2) provides that a sale or exchange is deemed to be by reason of a change in place of employment if –
    • The change in place of employment occurs during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence, and
    • The taxpayer’s new employment is at least 50 miles farther from the residence than the former employment

4.  §1.121-1(b) provides that whether a property is used by the taxpayer as a residence depends upon all the facts and circumstances. Relevant factors include, but are not limited to –

  • Place of employment
  • Principal place of abode of family members
  • Address listed on the taxpayer’s federal and state tax returns, driver’s license, auto registration, and voter registration card
  • Mailing address for bills and correspondence.
  • Location of taxpayer’s banks, and
  • Location of religious organizations and recreational clubs with which the taxpayer is affiliated.

5.  §1.121-1(c)(2)(i) provides that when establishing that the taxpayer has satisfied the 2-year use requirement, occupancy is required. Exceptions are made for short temporary absences such as vacation or other seasonal absences.

6.  §1.121-1(e) provides rules when property is used in part as a principal residence. This would apply to instances where a taxpayer uses a portion of their property for non-residential use and would include rental activities as well as a home office.

If the non-residential unit and the taxpayer’s dwelling unit are in fact separate units, the gain must be allocated between both units. The gain allocated to the rental unit is not eligible for exclusion under §121 while the gain allocated to the taxpayer’s dwelling unit is eligible for exclusion under §121.

If the rental unit and the taxpayer’s dwelling unit are not separate units, no allocation of gain is necessary as it is all eligible for exclusion under §121 (except for the portion of gain attributable to prior depreciation. This portion will always be taxable.)

The above regulation provides examples to illustrate this distinction. Three are cited below –

Example 3 – Non-residential use of a separate dwelling unit

“(i) In 2002 Taxpayer C buys a 3-story townhouse and converts the basement level, which has a separate entrance, into a separate apartment by installing a kitchen and bathroom and removing the interior stairway that leads from the basement to the upper floors. After the conversion, the property constitutes 2 dwelling units within the meaning of paragraph (e)(2) of this section. C uses the first and second floors of the townhouse as his principal residence and rents the basement level to tenants from 2003 to 2007. C claims depreciation deductions of $2,000 for that period with respect to the basement apartment. C sells the entire property in 2007, realizing gain of $18,000. C has no other section 1231 or capital gains or losses for 2007.

(ii) Because the basement apartment and the upper floors of the townhouse are separate dwelling units, C must allocate the gain between the portion of the property that he used as his principal residence and the portion of the property that he used for non-residential purposes under paragraph (e) of this section. After allocating the basis and the amount realized between the residential and non-residential portions of the property, C determines that $6,000 of the gain is allocable to the non-residential portion of the property and that $12,000 of the gain is allocable to the portion of the property used as his residence. C must recognize the $6,000 of gain allocable to the non-residential portion of the property ($2,000 of which is unrecaptured section 1250 gain within the meaning of section 1(h), and $4,000 of which is adjusted net capital gain). C may exclude $12,000 of the gain from the sale of the property.” (Italics added).

Example 4 – Separate dwelling unit converted to residential use

“The facts are the same as in Example 3 except that in 2007 C incorporates the basement of the townhouse into his principal residence by eliminating the kitchen and building a new interior stairway to the upper floors. C uses all 3 floors of the townhouse as his principal residence for 2 full years and sells the townhouse in 2010, realizing a gain of $20,000. Under section 121(d)(6) and paragraph (d) of this section, C must recognize $2,000 of the gain as unrecaptured section 1250 gain within the meaning of section 1(h). Because C used the entire 3 floors of the townhouse as his principal residence for 2 of the 5 years preceding the sale of the property, C may exclude the remaining $18,000 of the gain from the sale of the house.”

Example 5 – Non-residential use within the dwelling unit, property depreciated

“Taxpayer D, an attorney, buys a house in 2003. The house constitutes a single dwelling unit but D uses a portion of the house as a law office. D claims depreciation deductions of $2,000 during the period that she owns the house. D sells the house in 2006, realizing a gain of $13,000. D has no other section 1231 or capital gains or losses for 2006. Under section 121(d)(6) and paragraph (d) of this section, D must recognize $2,000 of the gain as unrecaptured section 1250 gain within the meaning of section 1(h). D may exclude the remaining $11,000 of the gain from the sale of her house because, under paragraph (e)(1) of this section, she is not required to allocate gain to the business use within the dwelling unit.”

7.  1.121-1(e)(3) provides a method of allocating gain between two different units that are part of a single property. The basis and the amount realized must be allocated using the same method of allocation the taxpayer used to determine depreciation deductions.

8.  Based on the application of §1.121(e) and Example 3 specifically, Unit 1 and Unit 2 are in fact separate units and not part of the same dwelling unit. This means that John and Jane Doe can’t meet the use and ownership tests under §121(a) and §1.121-1(c) for both units but can only meet the tests for one or none.

9.  §121(d)(7) provides that any portion of the gain on the sale of the property attributed to prior depreciation may not be excluded under §121. Depreciation is defined in §1250(b)(3).

10.  For the 5-year period ending August 2015, the Does used Unit 1 as their principal residence from August 2010 at least through March 2012. This totals 20 months of use as defined under §1.121-1(c)(2)(i) where the taxpayers occupied the unit.

11.  Because Unit 1 and Unit 2 are separate units for purposes of §121, the Does must meet the ownership and use test for one unit or another to exclude the gain attributable to that unit. They cannot exclude the gain allocated to both.

  • Unit 1 Gain Exclusion – No portion of the gain on the sale of Unit 1 may be excluded under §121 because:
    • The use test of 2 out of the last 5 years is not met because the taxpayers only had 20 months of use, not 24. The taxpayer must occupy the unit to meet the use test.  Since the Does only occupied Unit 1 for 20 months they fail the use test.
    • The taxpayers are not eligible for a reduced or pro-rated exclusion amount under §121(c) because John Doe’s employment did not change while Unit 1 was his principal residence. The sale was also not due to changes in health or unforeseen circumstances.
  • Unit 2 Gain Exclusion –  Unit 2 became the Does principal residence in April of 2012. This means that from August 2010 to August 2015 (the five-year testing period), the Does occupied Unit 2 for 40 out of the 60 months.
    • Because the Does occupied Unit 2 for at least 2 out of the last 5 years, they meet the use test under §1.121-1(c).
    • Because the first 20 months of the 5-year testing period were non-qualified use, §121(b)(5) requires that a portion of the Unit 2 gain be allocated to this period of non-qualified use. This portion is not eligible for exclusion under §121.  Had the non-qualified use occurred in the last 20 months rather than the first 20 months, the entire gain related to Unit 2 could be excluded under §121 per the exception in §121(b)(5)(C)(ii) (except for prior depreciation on Unit 2).
  • Allocation of overall gain to Unit 1 and Unit 2
    • The same method used to allocate basis for purposes of depreciation must be used to allocate basis and amount realized to determine gain on the sale of the property.

Conclusion:

1.  How much of the gain on the sale of the property will be taxable?

  • All prior depreciation
  • All of the gain allocated to Unit 1
  • 1/3 of the total gain (20 months/60 months) allocated to Unit 2

2.  How much of the gain on the sale of the property will not be taxable?

  • 2/3 of the total gain (40 months/60 months) allocated to Unit 2, less prior depreciation

3.  Because the Doe’s home is a capital asset under §1221, the character of the gain is capital. The portion of gain attributable to prior depreciation is unrecaptured §1250 gain as defined in §1(h)(6) and in reference to §1250.  The capital gain is taxed at a maximum 20% rate and the unrecaptured §1250 gain is taxed at a maximum 25% rate.