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Washington DC Attorneys

01/11/10: Is Your Home Your Castle?

HOUSING COUNSEL

By Benny L. Kass

"Income tax returns are the most imaginative fiction being written today."
Herman Wouk

The concept of "principal residence" is critical in our tax laws. In order to qualify for the first time homeowner tax credit, the home you buy must be your main home. In order to claim the up-to-$500,000 exclusion of gain (or $250,000 if you are not married and file a separate tax return) when you sell your home, that property must be your primary residence.

When you file your annual income tax return, you can deduct the interest you pay on your mortgage (up to a certain limit), and you can also deduct the real estate tax which you pay to your State and local governments.

In order to qualify for these tax benefits, however, the home in which you live must be your legal, principal residence. And although some of these deductions are also available for investment properties, this column will address only your personal home.

There is no statutory definition for principal residence in the Tax Code. If you ask an IRS agent -- or your tax attorney -- for a definition, she will advise you 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." Even in IRS publications, there is no clear-cut definition. According to Publication 17, entitled "Your Federal Income Tax for Individuals", the IRS merely states "usually, the home in which you live in most of the time is your main home."

So how do you prove that your home is, in fact, your principal residence?

There have been very few court cases in which principal residence has been defined, but in those cases, the courts provide the same answer: we will investigate the facts of each case, and make our decision based on those specific facts, on a case-by-case basis.

If you have lived in the same home for many years, and consider it to be your principal home, it will clearly be your "principal residence." The key components which will guide and assist the Courts and the IRS in making their decision are:

  • where do you pay your state or local income tax?
  • where do you vote?
  • what is the address on your driver's license?
  • where do you get your mail?
  • the location of the banks you use, and
  • the location of recreational clubs and religious organizations to which you belong.

But if you moved out of your house and have been renting it for some time, does that mean that your home is no longer your principal residence? Not necessarily. You (and perhaps the IRS) will have to review the specific facts involving your particular situation, to make sure that you still qualify for the basic homeowner tax benefits. And it will also depend on which tax benefit you are trying to obtain.

For example, in order to qualify for the exclusion of gain, you only have to live in the house two out of the past five years prior to it being sold. Thus, if you sell your house in February of 2010, you can still claim it as your principal residence for purposes of taking the exclusion, so long as you actually lived in the house for two years between February of 2005 and the date of sale.

And the fact that you took a couple of weeks vacation during these two years does not change the situation. Short term or other seasonal absences are still considered as "use". The IRS provides the following example:

Professor Paul Beard, who is single, bought and moved into a house on August 28, 2005. He lived in it as his main home continuously until January 5, 2007, when he went abroad for a 1-year sabbatical leave. On February 6, 2008, he sold the house at a gain.
Because his leave was not a short temporary absence, he cannot include the period of leave to meet the 2-year use test. He cannot exclude any part of his gain because he did not use the residence for the required two years.

Here, we see the interplay between "facts" and "circumstances". A short term vacation or business trip absence will still be considered as "use", but a one year sabbatical will not. But the IRS does concede that the ownership and use requirements do not have to be continuous. According to the IRS, "the requirements ... may be satisfied during nonconcurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale..."

In its regulations, the IRS states 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 gives 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."

If the homeowner has two houses, and uses each as a residence for successive periods of time (such as alternating between Florida in the Winter and Washington during the rest of the year), the property that the homeowner uses a majority of the time during the year will usually be considered the principal residence. But you have to make sure that you live in one of them at least one day longer; I don't know what the IRS would do if you lived in both houses exactly six months during the year.

Indeed, there are circumstances which would permit you to have two principal residences. For example, in 2008 and 2009, you lived here in Washington, but in 2006 and 2007 you lived in Vermont. Each home will be considered your principal residence, but you can only claim the exclusion once every two years. So long as you have owned and used each property for the requisite two out of five years before sale, you can take the exclusion on both properties for the year each was sold. You must do the mathematics very carefully.

And it is to be noted that a cooperative housing apartment, a house trailer or a houseboat will also be considered a "principal residence", so long as there is a kitchen, sleeping quarters and bathroom facilities.

The operative words are "owned and used". If you are married, so long as either spouse meets the ownership requirement, and both meet the use test, the exclusion of gain applies. Marital status is determined on the date the house is sold. In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirement will include any time that the former spouse actually owned the property before the transfer to the other spouse.

There are times when a homeowner wants to have the house considered as "investment" rather than principal residence. For example, if you have made a significant profit (i.e. more than $500,000) and are faced with a sizable capital gains tax, you may want to consider doing an exchange under Section 1031 of the Internal Revenue Code. Keep in mind that you can only exchange investment properties, not principal residences.

If you have do not meet the use and occupancy requirements, you may still be eligible for the "reduced maximum exclusion". If the reason for selling your house was because of (1) a change in place of employment (i.e. the new job is at least 50 miles farther from your home), (2) health reasons, or (3) unforseen circumstances, you most likely will be able to exclude a portion of your gain. This requires some accounting skills in order to compute the amount of the exclusion you will be able to take. The reduced exclusion is equal to the number of days of use times the quotient of $500,000 divided by 730 days. Note that 730 days is 2 full years. If you are single -- or do not file a joint tax return -- change the $500,000 to $250,000.

There is an old adage that your home is your castle. Whether it will also be your principal residence will depend on how carefully you have preserved and documented all of the relevant facts.

(For a more comprehensive discussion, see IRS Publication 523, Selling Your Home, available free on the IRS Website, www.irs.gov., key in "forms and publications").

(Next: "Mortgage Interest Deductions")

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