Ins and Outs of Using ‘Over-55’ Tax Break in Sale of Residence
Recently, I met a gentleman in his mid-60s who was about to make a $125,000 mistake. He was planning to marry a woman in her late 50s, but that wasn’t his mistake. His costly error was that he was planning to sell his home and move to Florida, where he and his bride were to buy a home together.
However, he neglected to consider that his soon-to-be new wife had already used her once-per-lifetime $125,000 “over-55 rule” entitlement. If he waits to sell his home until after the wedding, he becomes ineligible to receive up to $125,000 in tax-free profits on his home sale. He should sell his home before--not after--the marriage.
This is just one of several pitfalls to anticipate when using the “over-55 rule.”
The “over-55 rule” of Internal Revenue Code 121 is quite easy to analyze. There are three parts. To qualify for up to $125,000 in tax-free home-sale profits, the home seller must be 55 or older on the day the principal residence is sold. The seller must have owned and lived in the house for three of the five years before its sale, and never have used this tax break before.
Initially, the age-55 test seems simple. It says the home seller must be 55 or older on the day of the principal residence’s sale. However, if the home is owned by only one spouse, that spouse must be the one who is 55 or older. If the home is owned by both spouses, remember that only one $125,000 home-sale tax exemption is allowed per marriage.
The requirement that you own and live in the home three of the five years before the sale seems easy. This allows the seller to move out of the home and rent it for up to two years before selling the home. Or the owner can sell the home after as little as three years of ownership and occupancy.
However, if you own more than one home, such as a summer home in Maine and a winter home in Arizona, you might have difficulty meeting the three-year occupancy test for your principal residence. If you spent six months at each home, then neither home could qualify because during the five years before the sale you would have occupied each house for just 30 months rather than the required 36 months. The law was recently amended, however, to allow extended absences for health reasons without losing occupancy time.
In second marriages, if one spouse has already used the “over-55 rule” exemption, the other spouse cannot qualify for this tax break. The reason is that both spouses must agree to the election, and the spouse who earlier used his or her exemption cannot use it again. This is called the “tainted-spouse rule.”
To avoid surprise, before marrying, it is wise to ask your intended spouse, “Honey, have you used your ‘over-55 rule’ $125,000 home-sale tax exemption yet?” If the answer is yes, but you are over 55 and plan to sell your home, sell it before getting married so you can use your exemption.
Incidentally, if the principal residence is owned by two or more co-owners who are not married to each other, such as two friends or two sisters, as long as they meet the age and other qualifications, then each co-owner can walk away from the sale with up to $125,000 of tax-free home-sale profits. Thus, two eligible co-owners could receive up to $250,000 in tax-free profits.
If your home-sale profits will be more than your $125,000 exemption, it is possible to shelter more than $125,000 of sale profits. This is done by combining the “over-55 rule” with the “roll-over residence replacement rule” of IRC 1034, which is available to home sellers of any age.
To illustrate, suppose you are 55 or older and your home sells for $295,000, but your cost was only $50,000, so you will have a $245,000 sale profit. To avoid paying any profit tax, presuming you are eligible for the “over-55 rule,” just subtract your $125,000 exemption from the $295,000 net price to arrive at a $170,000 “revised adjusted sale price.” Then buy a replacement principal residence costing at least $170,000 within 24 months before or after the sale and defer the tax on your remaining $120,000 sale profit.
