Americans Abroad: Sale of “Principal Residence”, Gain Exclusion & Unforeseen Circumstances

Section 121 of the US Internal Revenue Code allows for the exclusion of up to $250,000 ($500,000 for a married couple filing jointly) in gains arising from the sale of a “principal residence.”  The exclusion applies whether the residence is in the US or a foreign country.  The tax law is very specific in its rules. Aside from the fact that the home must qualify as the “principal residence”, certain “ownership” and “occupancy” requirements must also be satisfied.

 “Ownership” and “Occupancy” Tests

In order for a property to qualify as a principal residence, the residence must have been owned and occupied by the taxpayer for a minimum of 2 years (specifically, 730 days) during the five-year period ending on the property’s date of sale.  This can be one continuous period of residency, or multiple periods which total 730 days.

My earlier blog posting provides greater detail on the meaning of “principal residence”, the Section 121 permissible allowance for “short, temporary absence(s)” which may be counted towards the 2 year occupancy requirement and issues regarding filing of joint tax returns and claiming the exclusion. Another blog post focusses on ownership of the residence through an entity, such as a foreign corporation. This is fairly common in Middle Eastern countries where Sharia law is applied.   The issue here is that a “corporation” cannot own and use the residence since a corporation cannot be an occupant of the home.

This blog post will examine the allowance of partial exclusions of gain on sale of the home where the ownership and/or occupancy tests are not fully met.

Americans Abroad

Unique implications are raised under the “ownership” and “occupancy” tests for US individuals working abroad.  Perhaps an expatriate couple initially only intended to work overseas for a year or two, but have now found themselves staying for longer and have decided to consider selling their former residence back in America.  For this couple, time is of the essence.

Don’t’ Wait Too Long

There is effectively a time limit for taking advantage of the exclusions under Section 121. Waiting too long to sell a property can result in it no longer meeting the requirements of a “principal residence” since the law mandates that the residence must have been owned and occupied by the taxpayer for a minimum of 2 years in the five-year period ending on the date the residence is sold. Example: Mr. and Mrs. Torres own and resided in a home in New York since its purchase in 2010.  Mrs. Torres takes on employment in the United Arab Emirates and on January 1, 2013 the family moves there intending to stay no longer than 2 years. However, by 2017, the family is still happy in the Emirates with Mrs. Torres being given consistent promotions and salary increases. The couple sell the NY home in June 2017 at a substantial gain.  Under these facts, because the Torres’ did not occupy the NY home for 730 days in the 5-period ending on the date the home was sold (January 1, 2012 – June 2017), they cannot claim the $500,000 exclusion of gain.

Change in Employment, Health or Unforeseen Circumstances

Perhaps the expatriate has purchased a home abroad secure in the feeling that he will remain in the foreign location for a number of years.  What happens if the taxpayer becomes seriously ill, the overseas job is suddenly terminated, a better job is offered in another country, or, if living in the foreign country has become unsafe, such that the taxpayer must leave the foreign country selling the residence before meeting the “ownership” and “use” time frames required by the tax law?

Can anything be done in such situations to help qualify for the exclusion of gain on sale of the residence?

Section 121 allows for partial exclusion of gain even if a residence was not owned and/or occupied for the required time periods.  A taxpayer is permitted to exclude a portion of the gain pursuant to a special proration formula, but only if the sale was required “by reason of a change in place of employment, health, or … unforeseen circumstances.”  Some safe harbor rules are provided in the relevant Treasury Regulations (e.g., death, divorce/legal separation, illness/injury, or disaster resulting in casualty to the home). If the safe harbor is not met, then the tax law looks to the “facts and circumstances” of each case instead.  Generally, a sale is by reason of “unforeseen circumstances” if the primary reason for the sale is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence.

In the case of the overseas job being suddenly terminated, or if a better job is offered in another country, these types of cases may fit into the “change in place of employment” safe harbor. Safe harbor rules are also provided for cases involving one’s health. If living in the foreign country has become unsafe (e.g., due to war or terrorism), this type of situation may well fit into the exception for “unforeseen circumstances.”  Careful examination of the law and all of the facts with professional guidance is strongly advised before claiming the exclusion.  Complete certainty of outcome may be possible by requesting an Internal Revenue Service (IRS) private letter ruling. The IRS may issue rulings addressed to specific taxpayers identifying events or situations as “unforeseen circumstances” with regard to those taxpayers.

Recent IRS Private Letter Ruling

Recently, the IRS issued private letter ruling, PLR 201628002, permitting a couple who had a second child eligibility for a reduced exclusion of capital gain on sale of their principal residence based on the pro-ration formula, even though they did not meet any of  the safe harbors listed in the Treasury Regulations. The couple owned and resided in a small two bedroom condominium with one bedroom used by the couple. The second bedroom was a combination nursery, home office for the husband, and guest room. The wife became pregnant with a second child and after his arrival, the family moved to a larger home and was required to sell the condominium, prior to meeting the required time frames of Section 121.  The IRS agreed the arrival of the second child was an “unforeseen circumstance” sufficient to justify exclusion of a portion of the capital gain under Section 121.

Requesting a Private Letter Ruling

Requesting a private letter ruling from the IRS is time-consuming and generally expensive, with the IRS imposing its own fees for issuance of the ruling. These so-called “user” fees vary.  According to the IRS, user fees run from $200 to $28,300 depending on the type of ruling being requested.

Private letter rulings are directed to and can be relied upon only by the specific taxpayer requesting the ruling.  They cannot be cited as precedent by other taxpayers. Taxpayers with similar fact patterns can apply to the IRS for a private letter ruling specific to them; they cannot solely rely on a private letter ruling issued to a similarly situated taxpayer. PLR 201628002 is important, however, because it provides valuable guidance to taxpayers in similar circumstances that the IRS may again rule favorably when a taxpayer has to move because of the unexpected expansion of their family.

Gain On Sale – Tax Reporting Requirements

If all gains from the sale of a principal residence are excluded under Section 121, then unless you have received Form 1099-S, no additional reporting is required.  For gains exceeding $250,000 (or $500,000 in the case of a joint return), Form 1040 (Schedule D) and Form 8949 should be used.  The IRS lays out some of the rules for reporting the sale of your home in IRS Publication 523.  If you report the sale you should review the workings of the Net Investment Income Tax.  You can learn more about the Net Investment Income Tax on my blog posts here, here and here.

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