This exclusion applies if the taxpayer has owned and used the property as a principal residence for periods aggregating two years or more during the five years immediately preceding the sale or exchange of the residence. The exclusion applies to only one sale of a principal residence in any two-year period. The two-year ownership and use periods do not have to be concurrent for the exclusion to apply.
In determining if the two-year ownership and use periods are met, a taxpayer is treated as owning and using property as his or her principal residence during any period that a deceased spouse owned and used the property as a principal residence before death if:
- that spouse is deceased on the date the property is sold, and
- the taxpayer has not remarried at the time of the sale of the house.
In addition, if a taxpayer obtains property from a spouse or former spouse in certain divorce transactions, the period that the taxpayer owns the property for purposes of the two-year rule includes the period that the spouse or former spouse owned the property.
If the ownership and use requirements are not met, or if more than one principal residence is sold within a two-year period, a reduced exclusion may be available if the sale or exchange of the residence is due to a change in the taxpayer’s place of employment, health, or unforeseen circumstances.
The exclusion does not apply to certain sales of a principal residence acquired in a like-kind exchange. It generally is available only to individuals but, under certain circumstances, a bankruptcy estate or grantor trust may use the exclusion. The gain from the sale of a partial interest in a principal residence also may be excluded.
Generally, the exclusion is available only for the portion of the property that is used as a principal residence. The exclusion does not apply to gain allocable to any portion of the property that is not used as a principal residence if that portion of the property is separate from the dwelling unit. No allocation is required, however, if both the residential and non-residential portions of the property are within the same dwelling unit. However, in this case, the amount of the exclusion does not apply with respect to any depreciation adjustments taken for periods after May 6, 1997.
When the exclusion does not apply, any gain realized on the sale of the residence is capital gain income, which is taxed at reduced rates. Any loss realized on the sale of the residence is not deductible.
Section 1401 of the proposed provisions in the House Ways and Means Committee Chairman Dave Camp’s (R-MI) “Tax Reform Act of 2014” would require a taxpayer to own and use a home as the taxpayer’s principal residence for five out of the previous eight years to claim the primary residence exclusion of up to $500,000 for joint tax filers ($250,000 for single filers) on the gain of the sale of their principal residence. The exclusion also would be subject to an income phase-out, with the amount of excludable gain declining, dollar for dollar, as a taxpayer’s MAGI exceeds $500,000 ($250,000 for single filers).