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Principal Residence Subject to Definition

SPECIAL TO THE TIMES: Kass is a Washington, D.C., attorney who writes on real estate for The Times and the Washington Post.

The concept of “principal residence” is extremely important for most homeowners, but unfortunately, there is no real definition in the Tax Code.

Even the Internal Revenue Service has admitted 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.”

When you sell your home, there are certain tax benefits available to you--depending of course on whether your home was really your principal residence.

For example, if you sell your home and within two years buy another, you are probably eligible for the “rollover.” Although this will be discussed in greater detail later in this series, in general the rollover permits you to defer any profit you made on the sale of the previous home.

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Another example: you have lived in your home for three out of the last five years and are at least 55 years of age. If your home was your principal residence, you may be eligible for the once-in-a-lifetime exclusion of up to $125,000 of profit.

But, in every case, your home has to be your “principal residence.”

A review of the tax law shows that there have been very few cases in which the concept has been defined. Basically, the answer given by the courts is the same as that of the IRS: We determine principal residence on a case-by-case basis.

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

However, if you moved out of your house and have been renting it for some time, we must examine the facts relating to your particular situation.

In its regulations, the IRS 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 following illustration: “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.”

This, unfortunately, has become a common problem for homeowners here in California in recent years. You buy a new home but find that you cannot sell your old home as quickly as you would like. Rather than risk the financial burden of carrying two homes for a period of time, you decide to rent out either the old one or the new one for a little while.

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The tax courts have made it quite clear that a taxpayer is not required to have actually been occupying the old residence on the date of its sale. Again, we have to look to the particular facts and circumstances. More important, we have to look to the good faith of the taxpayer.

If you can demonstrate that in good faith you tried to sell your old house but were unable to because of market conditions, there should be no question that your old home will still be considered your principal residence for tax purposes.

However, keep in mind that to benefit from the tax saving laws, there are statutory time limits that have to be honored.

For example, the rollover requires that no more than two years can elapse between the sale and the purchase. Neither the IRS nor the courts have authority to extend this time.

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To qualify for the once-in-a-lifetime profit exclusion, you have to have lived in your old home three out of the last five years--unless you are in a nursing facility and then the time limitation is reduced to one year.

If you meet the statutory time restrictions, we then 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 so because of market conditions? Or was their real motive to keep the old house as investment property?

The burden of proof is on the taxpayer. You must be able to demonstrate that you did not abandon your house as a principal residence.

It should be noted that there are times when a homeowner wants to have the house considered as an “investment” rather than principal residence. For example, if you have made a significant profit and are not going to buy another principal residence for a number of years, you may want to consider doing an exchange under Section 101 of the Internal Revenue Code--and you can only exchange investment properties, not principal residences.

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Thus, if you want to preserve your home as your principal residence, what should you do?

First, make it clear that you are not abandoning your old house as your principal residence. Keep track of market conditions in your neighborhood and keep a log of your conversations with friends and real estate professionals.

Second, it is advisable to try to sell your house first before you rent it. According to some tax court cases, evidence of attempts to sell property have been looked at favorably by the courts in ruling on this question. Keep copies of any listing agreements with real estate brokers and any newspaper ads which have offered your house for sale.

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

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All of these factors will play a role in determining the facts and circumstances of your particular case.

One tax case suggested that the important elements were abode and the intention of remaining. Neither bodily presence alone nor intention alone were sufficient to create a residence; the court required a combination of acts and intention.

Thus, there is no easy answer to the question. But keep in mind that the rollover and the once-in-a-lifetime exclusion are among the few remaining tax benefits available for most homeowners. You certainly do not want to make a mistake and lose them.


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