Is Your Home Your Principal Residence?

When you sell your home, there are significant tax benefits available if it was your principal residence.

If within two years before or after you sell the home you buy another principal residence with a cost equal to or greater than the selling price of your old house, you can defer paying taxes on the capital gain you have made on your house.

If you are 55 or older, and you have lived in your principal residence three out of the past five years, you also are entitled to the once-in-a-lifetime capital-gain exclusion of up to $125,000.

While these issues will be discussed in detail in this series, an understanding of the concept of “principal residence” can save you a lot of money.

Unfortunately, there is no statutory definition of a principal residence. Even the Internal Revenue Service admits that “whether or not property is used by the taxpayer as his principal residence . . . depends on all the facts and circumstances in each case, including the good faith of the taxpayer.”

A review of the tax law indicates that there have been very few cases in which a definition of the concept was even attempted. Basically, the answer given by the courts is that it must be determined on a case-by-case basis.

Obviously, if you have been living exclusively in the same house for a number of years and consider it your principal home, then there is no question that it is your “principal residence.”

However, if you left the house and rented it out, we must examine the facts relating to your situation.

The IRS, in its regulations dealing with the rollover of the capital gain, has stated that “the mere fact that property is, or has been, rented is not determinative that such property is not used by the taxpayer as his principal residence.”

The IRS offers the example that “if the taxpayer purchases his new residence before he sells his old residence, the fact that he temporarily rents out the new residence during the period before he vacates the old residence may not, in light of all of the facts and circumstances of the case, prevent the new residence from being considered as property used by the taxpayer as his principal residence.”

The courts have made it clear that a taxpayer is not required to have actually been occupying the old residence on the date of its sale. According to one tax court opinion, “Relief is to be available even though the taxpayer moved into his new residence and rented the old one temporarily before its sale.”

It is important to remember that there are statutory time periods that cannot be waived or modified for both the rollover and the once-in-a-lifetime exemption.

To qualify for the rollover, no more than two years may elapse between the time you sold your old house and bought your new one--although it makes no difference whether you sell or buy first.

With the once-in-a-lifetime exemption, you must have used your old house at least three years during a five-year period ending on the date of the sale.

The only exception to this rule is when the owner becomes physically or mentally unable to care for himself, and is residing in a facility licensed by a state for persons in that condition. (Such facilities would include nursing homes.)

Under these circumstances, you must have owned and lived in your home as your principal residence for a total of at least one year during the five-year period.

If you meet the statutory time limitations, then we look to the facts involved in each case. The courts--and the IRS--take a careful look at the intent of the taxpayers. Did they, for example, truly intend to sell their house, but were unable to do so because of market conditions?

In the early 1980s, for example, it was often difficult to sell property because of high interest rates. Many taxpayers who bought a new house found that they were forced to rent their property out rather than carry the loss for a long period. Clearly, the same scenario is happening in today’s market.

Under these circumstances, if the intent of the taxpayer truly was to sell, then the IRS (and the courts) will still consider the home as a principal residence, even though it was rented for a temporary period of time.

In one case, the IRS ruled that a congressman had a principal residence in the District of Columbia even though he retained ownership of a residence in his home district that he used for lodging during his visits there.

The IRS ruled that the Washington home was the principal residence because property that the taxpayer occupies a majority of the time will be considered the principal residence. This is one of the most significant tests, namely, in which home do you primarily reside.

If, on the other hand, you had decided to rent your house for tax purposes, and later changed your mind, it may very well be argued that you abandoned the concept of a principal residence, changing it into investment property.

Indeed, there may be times when you want to consider the property as “investment” rather than principal residence.

For example, if you have made a significant profit and you are not going to buy another principal residence for a number of years, you may want to consider doing an exchange under Section 1031 of the Internal Revenue Code.

In such an exchange, if you swap one investment property for another investment property, you may be eligible to defer your gain and not pay taxes on the profit immediately. The details of 1031 exchanges will be discussed later in this series.

So if you want to preserve your home as your principal residence to take advantage of the two important tax benefits for the homeowner, what should the taxpayer do?

First, make it clear that you are not abandoning your old house as your principal residence. Perhaps you are renting it on a temporary basis, to determine whether you like the neighborhood in which your new house is located.

Second, you might want to try to sell your house first, to determine what the market will bring. According to some tax cases, evidence of attempts to sell property have been looked at favorably by the courts in ruling on this question.

Third, if you have not yet purchased a new house, have you tried to preserve your old house as your principal residence? For example, have you changed your voting registration? In which jurisdiction do you pay taxes? Have you changed your driver’s license? Have you told anyone that you no longer wish to return to your old house?

Each of these factors could play a role in the determination of which is your principal residence.

In one tax court case, the elements of residence were said to be the fact of abode and the intention of remaining, and the concept of residence was deemed to be a combination of acts and intention. Neither bodily presence alone nor intention alone were sufficient to create a residence.

Thus, there is no easy answer to the question of what is a principal residence. The facts of each case will assist you--and ultimately the IRS and the tax court--in determining whether your old house or your new house is or was your principal residence.

If the rollover and the once-in-a-lifetime exemption are important to you, make sure before you move out of your old house that you have carefully planned your next steps. You do not want to inadvertently do anything that could give rise to the conclusion that you have abandoned your principal residence. Once you have done so, it may be too late to correct that mistake.

Keep in mind that the rollover and the once-in-a-lifetime exclusion are among the few remaining tax benefits left for most homeowners. You certainly do not want to lose them accidentally.