Houses are considered a capital asset and therefore subject to capital gains tax; however, most homeowners are exempt and can exclude gains from selling their homes.
The 2014 case of Marvin E. Debough v. Commissioner of Internal Revenue displayed a time in which a homeowner was not exempt from paying capital gains tax after selling their home.
Read on to learn more about the updated qualifications homeowners must fulfill to exclude gains from selling their main home.
What is Home Sale Exclusion?
Home sale exclusion is an IRS rule that allows people who meet specific criteria to “exclude up to $250,000 for single filers or up to $500,000 for married filing jointly in capital gains tax from the profit they make on the sale of their home.” This rule, also called “sale of a personal residence exclusion,” contains an array of requirements and criteria.
How Does Home Sale Exclusion Work?
Capital gain or loss is the difference between the amount the seller sold the home for and the amount they paid for the property plus some qualifying costs. For example, a seller would gain $200,000 if they initially bought the property for $300,000 and sold it for $500,000. The seller would not have to report that $200,000 gain as taxable income because it is below the $250,000 exclusion for a single filer if they met the criteria.
How Do Sellers Qualify for the Home Sale Exclusion?
According to IRS, a taxpayer must meet the following criteria to exclude gains from selling their home:
The Two Year Ownership and Use Rule
To qualify for the home sale exclusion of $250,000 or $500,000, homeowners must occupy the property as a principal residence for at least two out of the last five years before selling it. The home can be an apartment, house, condominium, mobile home fixed to land, or stock cooperative.
For those who rent out their property, this rule can become tricky. We suggest hiring a tax professional to ensure you qualify for the exclusion before making the sale. However, as long as the owner lives in the home for at least two years out of the last five, they should qualify for the exclusion – even if they have rented it out for the last three years.
The Home Must be the Homeowner’s Principal Residence
The homeowner must use the home as their primary residence for two out of the last five years. In basic terms, a principal residence is a place where someone lives most of the time.
How Often Can Homeowners Qualify for the Exclusion?
As long as homeowners meet the other criteria, they can qualify for the exclusion any number of times. However, they cannot exclude gains from the sales of their homes more than once every two years. This allows homeowners to be able to buy and sell multiple homes over several years without paying income taxes on their profits.
Additionally, homeowners need to recognize gain on any portion of their residential property that they do not use for residential purposes in order to qualify for the exclusion.
Now that we understand home sale exclusion and how homeowners can qualify, let’s take a look at the Marvin E. Debough v. Commissioner of Internal Revenue case: Why didn’t Debough qualify for the exclusion?
Marvin E. Debough v. Commissioner of Internal Revenue
In 2006, Marvin Debough sold his personal residence that he had owned for 40 years. Debough sold his property with a sales contract stating that the buyers were to make installment payments until 2009 when the remaining balance would become due and payable.
After excluding $500,000 of the gain from the sale of the home, Debough reported $56,920 of taxable gain during 2006-2008. However, during 2006, 2007, and 2008, Debough received $505,000 of principal payments from the buyers. Eventually, the buyers defaulted and Debough reacquired the property in 2009.
IRS and Debough Disagreed
Debough and IRS agreed that he had gains to realize as a result of reacquiring the property but they disagreed on the amount.
Debough argued that most of the gain should be excluded as gain from the sale of a principal residence. IRS determined that his gain was $448,080 by deducting the $56,920 gain Debough reported in 2006-2008 from the $505,000 he received from the buyers during that period.
What Did IRS Claim in the Debough v. Commissioner Case?
IRS presented Internal Revenue Code Section 1038, which states that “If the reacquired property is resold within one year of the reacquisition, the resale is treated as part of the original sale.” IRS argued that because Debough did not sell the property within a year of reacquiring it, the home exclusion rule did not apply to him.
What Was the Outcome of the Marvin E. Debough v. Commissioner of Internal Revenue Case?
The Tax Court agreed with the reasoning provided by IRS and concluded that Debough had to recognize long-term capital gain from the reacquisition, including amounts previously excluded.
How Did the Marvin E. Debough v. Commissioner of Internal Revenue Case Affect Home Sale Exclusion?
Following the outcome of the Debough case, sellers became aware of the strict rules surrounding home exclusion and when they should sell properties. Installment sales, such as Debough’s, have different requirements than other primary residence sales.
For instance, if a homeowner sells their main home under an installment sale and later reacquires it because the buyer defaults, the seller should highly consider reselling the property within one year to avoid paying the additional taxes on the payments they received from the buyer, as Debough had to.
Home Sale Exclusion and Installment Sales
If a seller chooses to make an installment sale, a sale in which revenue and expenses are recognized at the time of cash exchange, IRS may have different requirements.
IRS states “if you sold your home under a contract that provides for all or part of the selling price to be paid in a later year, you made an installment sale… report the sale under the installment method unless you elect out. Even if you use the installment method to defer some of the gains, the exclusion of gain under Section 121 remains available.”
We suggest connecting with a tax professional to ensure you navigate the sale process as efficiently as possible and avoid any unnecessary tax consequences.
Read on to learn how to respond to an IRS audit in 2022, here.
Do You Have Questions About Selling Your Home in an Installment Sale?
For questions about the tax consequences of selling your real estate in an installment sale, or if you have been contacted by IRS or California Franchise Tax Board regarding your prior real estate sale, contact Milikowsky Tax Law.