The Taxpayer Relief Act of 1997 ("1997 Act") replaces the rollover and one-time exclusion provisions for sales of personal residences with a simplified exclusion amount that should benefit many taxpayers.
Prior Law
Under prior law, taxpayers had two options for avoiding immediate gain on the sale of a personal residence. One choice was a "rollover" of the gain to a new personal residence by reducing the taxpayers basis in the new residence. The rollover rule only deferred the gain (until the sale of the new residence), and it required that the cost of the new personal residence equal or exceed the sale price of the prior home and that the new home be purchased within two years (before or after) of the sale.
Prior law also allowed a one-time exclusion from income of $125,000 of gain by sellers 55 or over who had owned property and used it as their principal residence for three years or more during the five-year period ending on the date of the sale.
These rules encouraged taxpayers to roll gain over from residence to residence until they were age 55 and eligible for the one-time exclusion of $125,000. Congress felt that this pattern promoted an inefficient use of taxpayers financial resources by encouraging purchases of more expensive houses in order to avoid tax liability. This was particularly a concern for taxpayers moving from areas with high housing costs to lower-cost areas.
New Law
The 1997 Act eliminates the rollover and one-time exclusion provisions and creates a new exclusion from gain rule that is generally available every two years. Code Section 121 now allows a taxpayer to exclude up to $250,000 ($500,000 for certain married taxpayers filing joint returns) of gain realized on the sale or exchange of a principal residence if certain ownership and use requirements are met.
The $250,000 exclusion applies if, during the five-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayers principal residence for periods aggregating two years or more. The $500,000 exclusion amount is available for spouses filing a joint return for the year of the sale or exchange if either spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse has used the exclusion in the two-year period ending on the date of the sale or exchange. If these requirements are not met, the $250,000 exclusion can still be used on a joint return if one of the spouses meets the ownership and use requirements with respect to the property.
The new provision includes an exception to the two-year requirement for sales or exchanges due to the taxpayers change in place of employment, health, or (to the extent provided in regulations) unforseen circumstances. If these circumstances are met, the taxpayer is allowed a reduced exclusion which is based on the portion of the two-year period for which the ownership and use requirements were met. This reduced exclusion is available for spouses filing joint returns if either spouse meets these requirements. However, the reduced exclusion on joint returns appears to be a fraction of the $250,000 exclusion amount, because the $500,000 exclusion amount is not available unless both spouses meet the use requirement.
There is a key planning point to consider. Taxpayers can elect not to have the exclusion apply. This could be beneficial if a taxpayer meets the ownership and use requirements for two different residences during the preceding five years and expects to sell both residences within a two-year period. Under those circumstances, the taxpayer should reserve the exclusion for the residence with the larger expected gain.
There are also some exceptions to the new exclusion. Not surprisingly, the exclusion is ot available to individuals using expatriation to avoid tax. Also, for taxpayers who have rental or business use of their principal residence, the exclusion will not apply to depreciation allowable (and recaptured upon sale) for periods after May 6, 1997.
New Case Regarding Use Requirement
The Court of Federal Claims recently decided a case that may help clarify the application of the use requirement under the 1997 Act exclusion. Gummer v. U.S., No. 97-297 T., Fed. Cl. (April 30, 1998), involved a taxpayer who lived in a home for approximately 22 years, listed the home for sale, and moved to an apartment in expectation of the sale. Unfortunately, it took more than four years to sell the home, so that the taxpayer did not physically reside in the home for three out of the five years preceding sale in order to qualify for the one-time $125,000 exclusion under prior law.
The taxpayer reported a gain on the sale, and then filed a claim for refund alleging that she was entitled to the one-time exclusion based on her use (but not occupancy) of the property. The IRS rejected the claim because the taxpayers physical occupancy did not meet the three out of five years requirement under prior law. The court rejected the IRS position and held, as a matter of law, that whether a property is used as a principal residence for purposes of former Code Section 121 does not depend solely on physical occupancy and must be determined under a facts and circumstances analysis. This holding should have direct application to the use requirement under the new Code Section 121 exclusion.
Effective Date and Transition Rule
The new exclusion is effective for sales and exchanges of principal residences after May 6, 1997. There is also a special transition rule. A taxpayer who held a residence on August 5, 1997, can take advantage of the reduced exclusion during the two years following August 5, 1997, even if the sale or exchange of their residence is not because of a change in place of employment, health or other unforseen circumstances.