29.2 Meeting the Ownership and Use Tests
To qualify for the up-to-$250,000 exclusion, you must have owned and occupied a home as your principal residence for at least two years during the five-year period ending on the date of sale. The periods of ownership and use do not have to be continuous. The ownership and use tests may be met in different two-year periods, provided both tests are met during the five-year period ending on the date of sale (as in Example 3 below). You qualify if you can show that you owned the home and lived in it as your principal residence for 24 full months or for 730 days (365 × 2) during the five-year period ending on the date of sale. However, some of the gain on a sale after 2008 might not be excludable, even if the two-out-of-five-year ownership and use tests are met, if you use the residence after 2008 as a second home or rental property; see the discussion of the nonqualified use rule at the end of this section.
If you or your spouse serve on qualified official extended duty as a member of the uniformed services, Foreign Service of the United States, intelligence community, or Peace Corps, you can suspend the five-year test period for the years of qualified service; see below.
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Filing Tip
Short Absences
Short temporary absences for vacations count as time you used the residence.
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If you are a joint owner of the residence and file a separate return, the up-to-$250,000 exclusions applies to your share of the gain, assuming you meet the ownership and use tests.
If you are married and file a joint return, you may claim an exclusion of up to $500,000 if one of you meets the ownership test and both of you meet the use test (29.3).
If the ownership and use tests are not met but the primary reason for the sale was a change in the place of employment, health reasons, or unforeseen circumstances, an exclusion is allowed under the reduced maximum exclusion rules (29.4).
Even if the ownership and use tests are met, the exclusion is not allowed for a sale if within the two-year period ending on the date of sale, you sold another principal residence for which you claimed the exclusion. However, a reduced exclusion limit may be available (29.4).
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Court Decision
Use Test Must be Met for Newly Built Home Replacing Demolished Home
If a new house is built on the site of a former residence, the period of use of the old house does not count towards meeting the two-year use test for the new house. A couple wanted to remodel their home but, because of building code and permit restrictions, decided to demolish the old house and build a new one on the site. Once the new house was completed, they sold it for $1.1 million, which resulted in a $600,000 gain. On their joint return, they excluded $500,000 of the gain from their income. They had lived in the demolished home for a number of years but never lived in the newly constructed home.
The Tax Court agreed with the IRS that they did not qualify for the exclusion. The exclusion applies only if the dwelling sold was actually used by the taxpayer as a principal residence for the required two-out-of-five years before the sale. In this case, while the demolished home was used as a principal residence for the requisite period, the newly built home was not.
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EXAMPLES
1. From 2001 through August 2012, Janet lived with her parents in a house that her parents owned. In September 2012, she bought this house from her parents. She continued to live there until December 15, 2012, when she sold it at a gain. Although Janet lived in the home for more than two years, she did not own it for at least two years. She may not exclude any part of her gain on the sale, unless she sold because of a change in her place of employment, health reasons, or unforeseen circumstances (29.4).
2. John bought and moved into a house in January 2010. He lived in it as his principal residence continuously until October 1, 2011, when he went abroad for a one-year sabbatical leave. On October 1, 2012, he sold the house. He does not meet the two-year use test. Because his leave was not a short, temporary absence, he may not include the period of leave in his period of use in order to meet the two-year use test. He may avoid tax on gain if he sold because of a changed job location unforeseen circumstances, or poor health (29.4).
3. Since 1991, Jonah lived in an apartment building that was changed to a condominium. He bought the apartment on December 1, 2008. In February 2010, he became ill and on April 14 of that year he moved into his son’s home. On July 12, 2012, while still living there, he sold the apartment.
He may exclude gain on the sale because he met the ownership and use tests. The five-year period is from July 13, 2007, to July 12, 2012, the date of the sale of the apartment. He owned the apartment from December 1, 2008, to July 12, 2012 (over two years). He lived in the apartment from July 13, 2007 (the beginning of the five-year period) to April 14, 2010, a period of use of over two years.
4. In 2001, Carol bought a house and lived in it until January 31, 2009, when she moved and put it up for rent. The house was rented from March 1, 2009, until May 31, 2012. Carol moved back into the house on June 1, 2012, and lived there until she sold it on September 30, 2012. During the five-year period ending on the date of the sale (October 1, 2007 − September 30, 2012), Carol lived in the house for less than two years.
| Five-year period— |
Home use (months)— |
Rental use (months)— |
| 10/1/07–1/31/09 |
16 |
|
| 3/1/09–5/31/12 |
|
39 |
| 6/1/12–9/30/12 |
4 |
|
| Total |
20 |
39 |
Carol may not exclude any of the gain on the sale, unless she sold the house for health or employment reasons or due to unforeseen circumstances (29.4).
Military and Foreign Service personnel, intelligence officers, and Peace Corps workers can suspend five-year period.
You may elect to suspend the running of the five-year ownership and use period while you or your spouse is on qualified official extended duty as a member of the uniformed services or Foreign Service of the United States. The suspension can be for up to 10 years. It is allowed for only one residence at a time. By making the election and disregarding up to 10 years of qualifying service, you can claim an exclusion where the two-year use test is met before you began the qualifying service and after your return; see the Example below. Qualified official extended duty means active duty for over 90 days or for an indefinite period with a branch of the U.S. Armed Forces at a duty station at least 50 miles from your principal residence or in Government-mandated quarters. Members of the Foreign Service, commissioned corps of the National Oceanic and Atmospheric Administration, and commissioned corps of the Public Health Service who meet the active duty tests also qualify.
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Court Decision
Co-Owner Can Claim Full $250,000 Exclusion
A single taxpayer who sells her home at a gain after owning and using it for at least two of the five years preceding the date of sale can exclude up to $250,000 of gain from income. What if there are two co-owners: do they have to split the $250,000 exclusion? Yes, argued the IRS in a 2010 case, the $250,000 exclusion has to be shared, but the Tax Court allowed a full exclusion. The taxpayer owned a 50% interest in a home she used as her principal residence since February 1997. When the home was sold in 2005, her share of the gain was $264,644.50 (half of the $529,289 total gain). She excluded $250,000 of her gain on her 2005 return, but the IRS said she was only entitled to half of the full exclusion, or $125,000.
The Tax Court allowed the full $250,000 exclusion. The statute (Code Section 121) does not limit the exclusion for partial owners of a principal residence. In fact, an example in the IRS regulations specifically allows unmarried joint owners holding 50% interests in a home to each exclude up to the full $250,000 limit for their shares of the gain on a sale.
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Similarly, the five-year testing period is suspended for up to 10 years for intelligence community employees (specified national agencies and departments) and Peace Corps workers. The suspension rule for Peace Corps workers applies to Peace Corps employees, enrolled volunteers, or volunteer leaders for periods during which they are on qualified official extended duty outside the United States.
EXAMPLE
Michael bought a home in Maryland in March 2000 that he lived in before moving to Brazil in November 2003 as a member of the Foreign Service of the United States. He serves there on qualified official extended duty for eight years, until the end of 2011. In January 2012, he sells the Maryland home at a gain. He did not use the home as his principal residence for two out of the five years preceding the sale and so does not qualify for an exclusion under the regular rule. However, Michael can exclude gain of up to $250,000 by electing to suspend the running of the five-year test period while he was abroad with the Foreign Service. Under the election, his eight years of service are disregarded and his years of use from March 2000—November 2003 are considered to be within the five-year period preceding the sale. He thus meets the two-out-of-five-year test and can claim the exclusion.
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Caution
Residence Acquired in Like-Kind Exchange
A residence acquired in a like-kind exchange must be owned for at least five years before gain on its sale can qualify for the exclusion.
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Cooperative apartments.
If you sell your stock in a cooperative housing corporation, you meet the ownership and use tests if, during the five-year period ending on the date of sale, you:
1. Owned stock for at least two years, and
2. Used the house or apartment that the stock entitles you to occupy as your principal residence for at least two years.
Incapacitated homeowner.
A homeowner who becomes physically or mentally incapable of self-care is deemed to use a residence as a principal residence during the time in which the individual owns the residence and resides in a licensed care facility. For this rule to apply, the homeowner must have owned and used the residence as a principal residence for an aggregate period of at least one year during the five years preceding the sale.
If you meet this disability exception, you still have to meet the two-out-of-five-year ownership test to claim the exclusion.
Previous home destroyed or condemned.
For the ownership and use tests, you may add time you owned and lived in a previous home that was destroyed or condemned if any part of the basis of the current home sold depended on the basis of the destroyed or condemned home under the involuntary conversion rules (18.19).
No Exclusion for Nonqualified Use After 2008
Even if the two-out-of-five-year test for an exclusion is met, gain attributable to “nonqualified” use after 2008 will not be eligible for the exclusion on a later sale. The primary intent of the rule is apparently to deny an exclusion for some of the gain realized by taxpayers who convert a vacation home or rented residence to their principal residence and live in it for a few years before selling. However, the law as written is broader, treating any period in 2009 or later for which the home is not used as a principal residence by you, your spouse, or former spouse as “nonqualified use.” Nevertheless, the exceptions to the nonqualified rule listed below (particularly exception 1) lessen the potential impact of the nonqualified use rule.
Exceptions to nonqualified use.
There are exceptions that limit the impact of the nonqualified use rule. The law specifically exempts the following from the definition of post-2008 “nonqualified use”: (1) the period after you or your spouse have moved out of the home, so long as it is within the five years ending on the date of sale, (2) temporary absences from the residence, not to exceed two years in total, due to a change in employment, health reasons (such as time in a hospital or nursing home), or other unforeseen circumstances to be specified by the IRS, and (3) periods of up to 10 years (in aggregate) during which you or your spouse are on qualified official extended duty (duty station at least 50 miles from residence) as a member of the uniformed services, as a Foreign Service officer, or as an employee of the intelligence community.
The IRS has not yet released guidelines on “nonqualified use,” including any other possible exceptions, such as whether short-term rental periods will be disregarded. An IRS example in Publication 523 suggests that home office use (29.7) after 2008 is not considered nonqualified use.
Figuring the excludable gain.
To figure the exclusion on a sale where there is nonqualified use after 2008, the gain equal to post–May 6, 1997 depreciation (allowed or allowable (29.7)) is taken into account first. No exclusion is allowed for this depreciation amount (29.7); this is a long-standing rule that is not changed by the nonqualified use calculation.
The portion of the remaining gain that is allocable to nonqualified use is not eligible for the exclusion. The allocation is made by multiplying the gain by the following fraction:
You can use Worksheet 29-3 later in this chapter to make the allocation and figure your excludable and taxable gain.
EXAMPLES
1. The Joint Committee on Taxation gave this example to illustrate how the nonqualified use rule reduces the amount of gain that can be excluded: An individual buys a home on January 1, 2009, for $400,000, and uses it as rental property for two years, claiming $20,000 of depreciation deductions. On January 1, 2011, he converts the property to his principal residence. On January 1, 2013, he moves out and one year later on January 1, 2014 he sells the home for $700,000. Gain on the sale is $320,000 ($700,000 − $380,000 basis ($400,000 cost − $20,000 depreciation)). The $20,000 of depreciation is recaptured as income (without regard to the nonqualified use rule). Of the remaining $300,000 gain, 40% is attributable to a nonqualified use since during the five years that the home was owned, it was used as rental property for two years (2/5 = 40%). Thus, $120,000 of the gain (40% × $300,000) does not qualify for the exclusion and is taxable. The $180,000 balance of the gain ($300,000 − $120,000 allocated to nonqualified use) is excluded from income, as it is less than the $250,000 exclusion limit.
Note that even without the nonqualified use rule, only $250,000 of the $300,000 gain (after depreciation is recaptured) would have been excludable. The effect of the nonqualified use rule under these facts is to reduce the excludable gain by an additional $70,000, from $50,000 ($300,000 − $250,000) to $120,000 under the allocation formula.
2. Andrea owned and lived in her principal residence from 2006 through 2009 and then moved to another state. She rented the home from January 1, 2010 until April 30, 2012, when she sold it. Andrea met the ownership and use test: she owned and lived in the house for more than two years in the five-year period ending on the date of sale (May 1, 2007 − April 30, 2012). Although Andrea rented out the home after 2009, the rental period (January 1, 2010 − April 30, 2012) is not considered nonqualified use because it was after she moved out of the home and was within the five-year period ending on the sale date. Andrea may exclude gain of up to $250,000, but not gain equal to the depreciation she claimed (or could have claimed) while the house was rented. Because the property was rented at the time of sale, the IRS requires the sale to be reported and the exclusion claimed on form 4797.
