When you sell your home, if it is your principal residence, there are significant tax benefits available. If you sell your principal residence, and within two years before or after you sell you buy another principal residence, with a cost equal to or greater than the selling price of your house, you become eligible for a rollover, which defers the gain you made on your house.
If you are 55 years or older, and you have lived in your principal residence three of the past five years, you also are entitled to the once-in-a-lifetime exclusion of gain up to $125,000. The concept of principal residence is extremely significant, and certainly can save you a lot of money if you understand the principles.
Unfortunately, there is no statutory definition of a principal residence. Even the Internal Revenue Service admits that "whether or not property is used by the taxpayer as his principal residence ... depends on all the facts and circumstances in each case, including the good faith of the taxpayer."
A review of the law indicates that there have been few cases in which a definition of the concept was even attempted. Basically, the answer given by the courts is that it must be determined on a case-by-case basis.
Obviously, if you have been living exclusively in the same house for a number of years and consider it your principal home, then there is no question that it is your "principal residence." However, if you left the house and rented it out, we then have to look at the specific facts relating to your situation.
The IRS, in its regulations dealing with the rollover, has stated that "the mere fact that property is, or has been, rented is not determinative that such property is not used by the taxpayer as his principal residence." The IRS goes on to give an example that "if the taxpayer purchases his new residence before he sells his old residence, the fact that he temporarily rents out the new residence during the period before he vacates the old residence may not, in light of all of the facts and circumstances in the case, prevent the new residence from being considered as property used by the taxpayer as his principal residence."
The courts have made it quite clear that a taxpayer is not required to have actually been occupying the old residence on the date of its sale. According to one tax court opinion, "relief is to be available even though the taxpayer moved into his new residence and rented the old one temporarily before its sale."
Keep in mind that for both the rollover and the once-in-a-lifetime exemption, there are statutory time periods that cannot be waived or modified. To qualify for the rollover, no more than two years may elapse between the time you sold your old house and bought your new one -- although it makes no difference whether you sell or buy first. With respect to the once-in-a-lifetime exemption, you must have used your old house at least three years during a five-year period ending on the date of the sale. The only exception to this rule is where the owner becomes physically or mentally unable to care for himself, and is residing in a facility licensed by a state (including nursing homes) for persons in that condition. Under these circumstances, you must have owned and lived in your home as your principal residence for a total of at least one year during the five-year period.
If you meet the statutory time limitations, then we look to the facts involved in each case. The courts -- and the IRS -- take a careful look at the intent of the taxpayers. Did they, for example, truly intend to sell their house, but were unable to do so because of market conditions? In the early 1980s, for example, it was often difficult to sell property because of high interest rates, and many taxpayers who bought a new house found that they were forced to rent out their property rather than carry the loss for a long period of time. Clearly, the same scenario is happening in today's market conditions. Under these circumstances, if the intent of the taxpayer truly was to sell, then the IRS (and the courts) will still consider the home as a principal residence, even though it was rented for a temporary period of time.
If, on the other hand, you decided to rent your house for tax purposes, and later changed your mind, it may very well be argued that you abandoned the concept of a principal residence, changing it into investment property.
Indeed, there may be times when you may want to consider the property as "investment" rather than a principal residence. For example, if you have made a significant profit, and you are not going to buy another principal residence for a number of years, you may want to consider doing a like kind exchange under Section 1031 of the Internal Revenue Code. While this concept will also be discussed later in this series, if you exchange one investment property for another investment property, you may be eligible to defer your gain, and not pay taxes on the profit immediately.
Thus, if you want to preserve your home as your principal residence, so as to take advantage of the two important tax benefits for the homeowner, what should you do?
First, you should make it clear that you are not abandoning your old house as your principal residence. Perhaps you are renting it on a temporary basis, to determine whether you like the neighborhood in which your house is located.
Second, you might want to try to sell your house first, to determine what the market will bring. In some cases, evidence of attempts to sell property have been looked at favorably by the courts in ruling on this question.
Third, if you have not yet purchased a new house, have you tried to preserve your old house as your principal residence? For example, have you changed your voting registration? In which jurisdiction do you pay taxes?
All of these factors could play heavily in the determination of what is your principal residence. In one tax court case, the elements of residence were said to be the fact of abode and the intention of remaining, and the concept of residence was deemed to be a combination of acts and intention. Neither bodily presence alone nor intention alone were sufficient to create a residence.
Thus, there is no easy answer to the question of what is a principal residence. The facts of each case will assist you -- and ultimately the IRS and the tax court -- in determining whether your old house and your new house is or was your principal residence.
If the rollover and the once-in-a-lifetime exemption are important to you, make sure before you move out of your old house that you have carefully planned your next steps. You do not want to inadvertently do anything that could give rise to a conclusion that you have abandoned your principal residence. Unfortunately, once you have done so, it may be too late to correct those mistakes.
Keep in mind that the rollover and the once-in-a-lifetime exclusion are among the few remaining tax benefits for most homeowners. You certainly do not want to lose these valuable tools accidentally.
Kass is a Washington attorney. For a free copy of the booklet, "A Guide to Settlement on Your New Home," send a self-addressed, stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.