Source: http://ca-elderlaw.com/realestate/principalresidencesale.html
Timestamp: 2019-04-24 03:56:29+00:00

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The proposed regulations to IRS Code Section 121 offer detailed guidance on how to take advantage of the exclusion from gross income when the principal residence is sold. Every elder law attorney who advises clients regarding the use, occupancy, and disposition of a principal residence must become familiar with these proposed regulations.
The Taxpayer Relief Act of 1997 amended Code Section 1214 and repealed Code Section 1034 for sales and exchanges of a principal residence that occur after May 6, 1997. Under the new Section 121, a taxpayer can generally exclude up to $250,000 ($500,000 for married couples filing a joint return) of gain realized on the sale or exchange of the taxpayer’s principal residence if for at least two years out of the five-year period immediately preceding the date of sale, the taxpayer owned and used the property as a principal residence. The exclusion from gross income applies regardless of the age of the taxpayer, and the full exclusion can be used once every two years.
The requirements of ownership and use for periods aggregating two or more years may be satisfied by establishing ownership and use for twenty-four months or for 730 days. The requirements of ownership and use may be satisfied during nonconcurrent periods if both the ownership and use tests are met during the five-year period ending on the date of sale.
In establishing whether a taxpayer has satisfied the two-year use requirement, occupancy of the residence is required. Nevertheless, short temporary absences, such as for vacation or other seasonal absence, even if the property is rented during such temporary absence, will be counted as use.
The facts of PLR 200104005 are as follows: Prior to the death of the wife, both the husband and wife had conveyed their principal residence to a trust they had established. The husband and wife had owned and used the residence as their principal residence for more than thirty years prior to the date of the wife’s death. The husband continued to use and occupy the house as his principal residence after the death of the wife. Due to health reasons, it was necessary for the husband to move out of the house and into an assisted living facility.
The trust that owned the house was revocable until the death of the wife. Upon the death of the wife, the trust was divided into two trust, Trust A and Trust B. Trust A, which remained revocable by the husband, contained all the husband’s interest in the community property estate, plus a portion of the wife’s interest in the community property, to satisfy the maximum marital deduction formula that was used in the trust document. The balance of the community estate, including the entire value of the principal residence, was allocated to Trust B. After the death of the wife, the husband did not have the authority to revoke or amend Trust B.
Trust B, in each calendar year, an amount that did not exceed $5,000 or five percent of the then aggregate market value of all property in Trust B.20 Trust B specifically provided that the husband had the right to occupy the residence and to direct the trustee to sell the residence and replace it with or rent or lease another residence of comparable or lesser value as selected by the husband.
The IRS ruled that the exclusion from gross income for the sale of a principal residence was not available to Trust B. The husband may exclude a portion of the gain under Section 121 to the extent the husband is deemed to be an owner of Trust B under the grantor tax rules. The husband’s right to vest a portion of the corpus of Trust B to himself by reason of the five and five power makes the husband the owner of that portion of the trust under Section 678(a)(1).
Because Trust B granted the husband the annual right to exercise, release or allow his five and five power to lapse, his ownership interest in the corpus of Trust B, for purposes of the grantor trust rules, will increase each year. The husband’s annual ownership increase is calculated by multiplying that portion of the corpus of Trust B that the husband could withdraw by a fraction, the numerator of which is the portion of the trust corpus that the husband is not already treated as the owner, and the denominator of which is the total trust corpus from which the withdrawal could be made.
The IRS went on to state the power granted to the husband under Trust B to "occupy all real property owned by the trust estate being used for residential purposes and to direct the trustee to sell the property and replace it with rent, or lease another residence selected by the taxpayer of comparable or lower value," is not a power to vest the corpus in the husband. As a result, the husband will not be treated as an owner of any additional portion of the corpus of Trust B under Section 678(a)(1).
If a married couple filing a joint tax return does not meet all three requirements for claiming the $500,000 exclusion as required under Code Section 121(b)(2)(A), the couple can exclude the sum of the amounts that each spouse would be entitled to claim if such spouse had not been married.23 In other words, the maximum exclusion that may be claimed by the couple is the sum of each spouse’s maximum exclusion determined on a separate basis.
If the home is transferred to a spouse or former spouse pursuant to a decree of divorce, the period of time that the taxpayer making the transfer owned the property will be added to the time that the spouse or former spouse who received the property owns the property.
Example: The terms of Bob and Linda’s divorce decree require Bob to quit claim his interest in the home to Linda. Under Section 121(d)(3)(A), Bob’s ownership interest will carryover to Linda. However, Linda must satisfy the two out of five-year use test on her own to qualify for the entire exclusion. The time Linda occupied the home as her principal residence prior to and after the divorce will count toward the two-year use test.
Example: Bob and Linda’s divorce decree gives occupancy of the home to Linda until their youngest child reaches the age of twenty-one. When their youngest child reaches the age of twenty-one, the home is to be sold and proceeds divided between Bob and Linda. At the time of the divorce, the youngest child is twelve years old. Provided Linda uses the home as her principal residence during this period, Linda’s use of the property as her principal residence will be imputed to Bob even though Bob has not used the property as his principal residence for more than five years. As a result, Bob will be entitled to claim the exclusion under Section 121 when the property is sold.
It is critical to incorporate language in the divorce decree that requires the occupying spouse to continue to use the property as his or her principal residence. Otherwise, the non-occupying spouse may lose the exclusion and be required to pay tax on his or her share of the sale proceeds.
To minimize the impact of the modified carryover basis rules created by the Economic Growth and Tax Reconciliation Act of 2001,36 a new paragraph nine was added to Section 121(d).37 Effective for decedents dying after December 31, 2009,38 the $250,000 exclusion is extended to estates, heirs and certain revocable trusts. Under new Section 121(d)(9), an estate or heir can exclude $250,000 of gain if the decedent used the property as his or her principal residence for two or more years during the five-year period prior to the sale.39 In addition, if an heir occupies the decedent’s home as his or her principal residence, the decedent’s period of ownership and occupancy can be added to the heir’s subsequent ownership and occupancy in calculating the two out of five years ownership and use test.
Under Section 121(d)(9)(C), the $250,000 exclusion is also extended to property sold by a trust provided that the trust was a qualified revocable trust, as defined under Section 645(b)(1), immediately prior to the decedent’s death. Any period of occupancy and ownership of the decedent can be extended to an heir’s subsequent ownership and use regardless of whether the principal residence was owned by a trust established by the decedent.
Section 121(d)(6) provides that the exclusion under Section 121 will not apply to the extent that depreciation attributable to periods after May 6, 1997 exceeds the gain allocated to the business-use portion of the property.40 Although gain must be recognized, pursuant to Section 121(d)(6), the fact that a taxpayer uses the principal residence as a rental does not preclude the application of the Section 121 exclusion.
Although similar rules applied to business use of a residence under prior Sections 1034 and 121, a taxpayer could avoid the recognition of gain by stopping all business use of the property immediately prior to sale.44 Under current law, a taxpayer must cease all business use of the property two full years prior to the sale to avoid recognition of gain under Section 121.
Although it is not specifically addressed in the proposed regulations, it seems clear that the "sold separately" language is referring to a sale in which the taxpayer sells a partial interest while retaining a partial interest.48 If the taxpayer originally acquired a partial interest, such as an undivided fifty percent interest, and then sold the entire fifty percent interest in one transaction, the sale should be excluded from income under Section 121 provided all other requirements of the statute are satisfied.
It is less clear whether Section 121 will apply to a sale of a partial interest where the taxpayer at some time had owned the entire interest in the property. For example, if a retained life estate was sold by a taxpayer who had previously elected to exclude the sale of the remainder interest in that property in a previous transaction, the partial interest rule under 121(d)(8)(A) may deny the application of the exclusion.
Section 311(e) of the Tax Relief Act of 1997 allows a non-corporate taxpayer holding a capital asset on January 1, 2001, to treat that asset as having been sold and reacquired on that date for an amount equal to its fair market value. The taxpayer must recognize gain equal to the difference between the fair market value of the property on the date of the election, less the property’s adjusted basis, but the taxpayer receives a corresponding tax benefit by starting the new holding period for post-2001 with reduced long-term capital gains rates of eight percent and 18 percent. There is no language under Section 311(e) to prevent a taxpayer from making a deemed sale election of the taxpayer’s principal residence. The issue that arises is whether a taxpayer making a Section 311(e) election on his or her principal residence can exclude the mandated gain recognition by reason of the Section 121 exclusion.
The IRS held in Revenue Ruling 2001-5749 that taxpayer cannot exclude from gross income under Section 121 any of the gain resulting from the deemed sale. The IRS based its ruling on the premise that the application of Section 121 to a Section 311(e) election would otherwise prevent the intended consequences of the mandated recognition under Section 311(e).
Under pre-1997 Act law, taxpayers were required to report the sale price of the old residence, its basis, and the purchase price of the new residence on Form 2119. Form 2119 is no longer used by the IRS; therefore, no information is required to be filed with a taxpayer’s return if all the gain is excluded under Section 121.
The proposed regulations on Code Section 121 offer detailed guidance on how to take advantage of the exclusion from gross income when the principal residence is sold. Every elder law attorney who advises clients regarding the use, occupancy and disposition of a principal residence must become familiar with the new proposed regulations to Code Section 121.
Bradley J. Frigon is Special Counsel with the law firm of Inman Flynn & Biesterfeld, P.C. in Denver, Colorado. He received his Juris Doctor Degree in 1981 from Washburn University in Topeka, Kansas and his Master of Law Degree in Taxation in 1982 from the University of Denver. He is a member of the American Bar Association, Colorado Bar Association, and the Kansas Bar Association. He is the chairperson of the Tax Special Interest Group of the National Academy of Elder Law Attorneys.
Proposed Treasury Regulations, Exclusion of gain from sale or exchange of a principal residence, 65 Fed. Reg. 60,136 (October 10, 2000).
Taxpayer Relief Act of 1997, No. 105-34, §312(d)(2) & (4).
Internal Revenue Service Restructuring and Reform Act of 1998, No. 105-206, §6005(e)(1) & (2) (1998).
All code section references are to the Internal Revenue Code of 1986, as amended.
The IRS will not issue rulings or determination letters concerning whether property qualifies as the taxpayer’s principal residence for purposes of Code Section 121. Rev. Proc. 2000-3, 2000-1 I.R.B. 130, Section 3.01(6). The proposed regulations do not address how much property surrounding the structure itself can be excluded under Section 121. For a discussion of this issue, see generally, Daughtrey et al., How Much Acreage Can be Included Under the New Sale of Principal Residence Rules?, 90 J. TAX’N 294 (1999); Megaard & Megaard, Reducing Taxes on the Disposition of a Personal Residence with Acreage, 20 J. REAL EST. TAX’N 269 (1993).
Prop. Treas. Reg. §1.121-1(c), 65 Fed. Reg. 60, 136 (October 10, 2000).
Id. at §1.121-1(f), Example 11.
Id. at §1.121-1(b). Under Proposed Reg. Section 1.121-1(b), the ownership text is applied to the taxpayer’s ownership of the stock, and the use requirement is applied to the home or apartment that the taxpayer is entitled to occupy as the stockholder.
Id. at §1.121-1(f), Example 3.
Priv. Ltr. Rul. 200029046 (April 24, 2000).
Priv. Ltr. Rul. 200119014, revoking Priv. Ltr. Rul. 200004022.
Rev. Rul. 85-45, 1985-1 C.B. 183.
Rev. Rul. 66-159, 1966-1 C.B. 162.
Priv. Ltr. Rul. 200104005 (September 11, 2000).
Under Section 2041(b), a lapse of a power of appointment does not occur to the extent such power of appointment does not exceed the greater of $5,000 or five percent of the aggregate value at the time of such lapse of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could have been satisfied.
Prop. Treas. Reg. §1.121-2(b)(3), Example 3.
Id. at §1.121-3(b), Example 1.
Id. at §1-121-2(b)(3), Examples 4 and 5.
H.R. 1836 P.L. 107-16, 115 Stat. 38.
Id. at §901 (providing that provisions of Section 121(d)(9) will not apply to estates or decedents dying after December 31, 2010).
Id. at §1.121-1(f), Example 1.
Id. at §1.121-1(f), Example 8.
Rev. Rul. 82-26, 1982-1 C.B. 114.
Under Code Sections 267(b) and 708(b), the family of an individual shall include only his brothers and sisters (whether by whole or half blood), spouse, ancestors, and lineal descendants.
Rev. Rul. 2001-57, 2001-46 I.R.B. 488.
I.R.C. §6045(e)(5) (see Announcement 97-106, 1997-45 I.R.B. 11 (Nov. 10, 1997) for information on what the IRS considers sufficient "written assurances").

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