When it comes to considering gross income for tax purposes, Section 121 of the US Internal Revenue Code allows for the exclusion of up to $250,000 in gains arising from the sale of a “principal residence.” The exclusion should apply whether the property is in the US or a foreign country. In the case of married couples filing a joint return, up to $500,000 may be excluded. The tax law is very specific in how it defines a “principal residence”, and in the “ownership” and “use” requirements that form part of the definition for utilizing this exclusion.
Principal Residence under Section 121
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. “Residence” is defined quite broadly and can include trailer homes and houseboats. The residence that the taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayer’s principal residence. However, this test is not dispositive. The Treasury Regulations provide a nonexclusive list of factors that are relevant in identifying a property as a taxpayer’s “principal residence”.
The definitional requirements raise some unique implications for US citizens 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 possibly looking to sell their former residence. 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”.
Timing of Sale
It is also important to note that the exclusion of gains under Section 121 can only be applied to the sale of one property every two years. If a taxpayer has two properties he is planning to sell, and has alternated in using each of them as a residence, it is possible for either to qualify under Section 121 if he has occupied each of them for the required 730 days out of the preceding five years. In order for both to qualify, they must be sold at least two years apart. This two year period is measured not in tax years, but as two calendar years from the date of sale of the first residence.
Absences from the Residence
Section 121 provides an allowance for “short, temporary absence(s)” which may be counted towards the 24-month occupancy requirement. This is permissible even if the taxpayer is not present, and even if the taxpayer has rented the property during the absence.
The tax law is vague about what constitutes a “short” and “temporary” absence. Annual two-month vacations are specifically mentioned as permissible, whereas a one-year sabbatical is not. Commentators had suggested that the IRS include exceptions to these rules for taxpayers who have been away for longer periods of time due to international employment, and have not purchased a new residence. The IRS specifically addressed these points when it adopted the final Treasury Regulations and stated it would not accept these suggestions.
The tax law allows for partial exclusions of gain if a residence was not occupied for the required 730 days during the five years leading up to the date of sale, 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. If the safe harbor is not met, then tax law looks to the facts and circumstances of each case instead.
Married couples filing jointly may exclude up to $500,000 on their return only if both of them have occupied the residence for the required 24 months over the five years preceding the date of sale, and at least one of them was the owner of that residence during the occupancy period. In addition, neither spouse may have excluded gains on the sale of a principal residence in the last two years.
In the case of a principal residence in a foreign country, co-owned with a spouse who is not a US citizen or US resident (e.g., a green card holder), the Section 121 exclusion may not exceed $250,000 because the non-US spouse’s share from gains on sale will not be subject to US taxes (this assumes the tax return is being filed using the status, “Married Filing Separately”). The couple can make a special tax election and file using the status “Married Filing Jointly” and thereby treat the non-US spouse as a US taxpayer. If this is done they can receive the $500,000 exclusion for gain on sale of the principal residence. More information on the tax filing options available when married to a non-US spouse can be found in my previous blog postings here (Part I) and here (Part II).
Keep in mind that additional taxes may apply in the country of residence and will also need to be considered.
Ownership through Entities
In general, Section 121 will not apply if the taxpayer owns the property through an entity such as a holding company. When a corporate entity owns the property, the ownership and occupancy/use tests cannot be met since the corporation cannot “occupy” or “live” in the residence. This is a troublesome area and will be examined more closely in another blog posting.
Properties owned through a trust are more complicated. Section 121 may apply if the taxpayer selling the property has met the 24-month occupancy requirement in addition to being considered the “tax owner” of the trust for the same period.
Expatriation and the Section 121 Exclusion
So-called “covered expatriates” who give up their US citizenship or green cards are, among other things, subject to what is commonly called, an Exit Tax. Basically, the individual is treated as if he has sold all of his worldwide assets at fair market value on the day before the expatriation date. Thus, the individual must pay US income tax on the deemed gain (the “Exit Tax”). The question, which will be addressed in another blog posting, is whether the individual can utilize the Section 121 exclusion in calculating this deemed gain.
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 here, and more detailed information can be found in IRS Publication 523. If you report the sale you should review the IRS Questions and Answers on 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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