Section 121 of the US Internal Revenue Code allows for the exclusion of up to $250,000 ($500,000 for a married couple filing jointly) in gains arising from the sale of a “principal residence.” The exclusion applies whether the residence is located Stateside or overseas. The tax law has very specific rules. Aside from the fact that the home must qualify as the “principal residence”, certain “ownership” and “occupancy” requirements must be satisfied.
Today’s blog post will run through the basics and examine the allowance of partial exclusions of gain on sale of the home when the ownership and/or occupancy tests are not fully met. For the American living and working overseas, there are special concerns that may arise in meeting the gain exclusion rules.
Let’s start with the basics.
“Ownership” and “Occupancy” Tests
In order for a property to qualify as a principal residence, the residence must have been owned and occupied by the taxpayer for a minimum of 2 years (specifically, 730 days) during the five-year period ending on the property’s date of sale. This can be one continuous period of residency, or multiple periods which total 730 days. In addition, the exclusion of gains under Section 121 can only be applied to the sale of one property every two years. If a taxpayer has two properties he is planning to sell, and has alternated in using each of them as a residence, it is possible for either to qualify under Section 121 if he has occupied each of them for the required 730 days out of the preceding five years. In order for both to qualify, they must be sold at least two years apart. This two year period is measured not in tax years, but as two calendar years from the date of sale of the first residence.
Ownership of a property through an entity deserves special mention, here. In general, Section 121 will not apply if the taxpayer owns the property through an entity such as a holding company. When a corporate entity owns the property, the ownership and occupancy/use tests cannot be met since the corporation cannot “occupy” or “live” in the residence. This is a troublesome area and one that is often seen in my practice. UAE properties might be subject to Sharia laws of inheritance and thus, it is often the case that the home is owned by a corporation rather than by the individual. Numerous tax implications are involved and complications can be easily avoided if proper tax planning is undertaken. Properties owned through a trust (or a foundation that is treated as a trust for US tax purposes) also present complexities. Section 121 may apply if the taxpayer selling the property has met the 730 days occupancy requirement in addition to being considered the “tax owner” of the trust for the same period.
The law provides a permissible allowance for “short, temporary absence(s)” which may still be counted towards the 2 year occupancy requirement. The tax law is vague about what constitutes a “short” and “temporary” absence. Annual two-month vacations are specifically permissible, whereas a one-year sabbatical is not. Commentators had suggested that the Internal Revenue Service (IRS) include exceptions to these rules for taxpayers who have been away for longer periods of time due to international employment, and have not purchased a new residence. The IRS specifically addressed these points when it adopted the final Treasury Regulations under Section 121 and stated it would not accept these suggestions.
Americans Abroad
Unique implications are raised under the “ownership” and “occupancy” tests for US individuals working abroad. Perhaps an expatriate couple initially only intended to work overseas for a year or two, but have now found themselves staying longer and have decided to consider selling their former residence back in America. Perhaps the couple bought a home overseas planning to live in the foreign country for many years, but may have had a change of heart later on. For either of these couples, time is of the essence.
Don’t Wait Too Long
There is effectively a time limit for taking advantage of the gain exclusion under Section 121. Waiting too long to sell a property can result in it no longer meeting the requirements of a “principal residence” since the law mandates that the residence must have been owned and occupied by the taxpayer for a minimum of 2 years in the five-year period ending on the date the residence is sold. Example: Mr. and Mrs. Money own and resided in a home in Massachusetts since its purchase in 2010. Mrs. Money takes on employment in the United Arab Emirates and on January 1, 2013 the family moves there intending to stay no longer than 2 years. However, by 2017, the family is still happy in the Emirates with Mrs. Money being given consistent promotions and salary increases. The couple sell the Massachusetts in June 2017 at a substantial gain. Under these facts, because the Money’s did not occupy the Massachusetts home for 730 days in the 5-period ending on the date the home was sold (January 1, 2012 – June 2017), they cannot claim the $500,000 exclusion of gain.
Partial Gain Exclusion – Change in Employment, Health or Unforeseen Circumstances
Perhaps the expatriate has purchased a home abroad secure in the feeling that he will remain in the foreign location for a number of years. What happens if the taxpayer becomes seriously ill, the overseas job is suddenly terminated, a better job is offered in another country, or, if living in the foreign country has become unsafe, such that the taxpayer must leave the foreign country selling the residence before meeting the “ownership” and “use” time frames required by the tax law?
Can anything be done in such situations to help qualify for the exclusion of gain on sale of the residence?
Section 121 allows for partial exclusion of gain even if a residence was not owned and/or occupied for the required time periods. A taxpayer is permitted to exclude a portion of the gain pursuant to a special proration formula, but only if the sale was required “by reason of a change in place of employment, health, or … unforeseen circumstances.” Some safe harbor rules are provided in the relevant Treasury Regulations (e.g., death, divorce/legal separation, illness/injury, or disaster resulting in casualty to the home). If the safe harbor is not met, then the tax law looks to the “facts and circumstances” of each case instead. Generally, a sale is by reason of “unforeseen circumstances” if the primary reason for the sale is the occurrence of an event that the taxpayer could not reasonably have anticipated before purchasing and occupying the residence.
The COVID-19 Factor
In the case of the overseas job being suddenly terminated, or if a better job is offered in another country, these types of cases may fit into one of the safe harbors. Many persons lost their jobs during the pandemic. As a result some were forced to sell their homes and pick up stakes because they took on other employment or because they were simply financially unable to maintain the residence. These could possibly be incidents covered by a safe harbor, or a “facts and circumstances” exception.
Safe harbor rules are also provided for cases involving one’s health and COVID-related illnesses may surely fit the parameters depending on the precise facts. For example, a sale or exchange is by reason of health if the “primary reason” for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury.
Careful examination of the law and all of the facts with professional guidance is strongly advised before claiming the exclusion. Complete certainty of outcome may be possible by requesting an IRS private letter ruling. The IRS may issue rulings addressed to specific taxpayers identifying events or situations as “unforeseen circumstances” with regard to those taxpayers. Generally, the private rulings indicate that the IRS’ interpretation of the term “unforeseen circumstances” is fairly broad and therefore very beneficial to taxpayers. See e.g., PLR 201628002, permitting a couple who had a second child eligibility for a reduced exclusion of capital gain on sale of their principal residence based on the pro-ration formula, even though they did not meet any of the safe harbors listed in the Treasury Regulations.
Requesting a Private Letter Ruling
Requesting a private letter ruling from the IRS is time-consuming and generally expensive, with the IRS imposing its own fees for issuance of the ruling. These so-called “user” fees vary.
The procedures and user fees for obtaining a letter ruling are published annually in the first revenue procedure of each calendar year. For 2021 please see Revenue Procedure 2021-1. Section 14 and Appendix A of the Revenue Procedure provide information on user fees.
Private letter rulings are directed to and can be relied upon only by the specific taxpayer requesting the ruling. They cannot be cited as precedent by other taxpayers. Taxpayers with similar fact patterns can apply to the IRS for a private letter ruling specific to them; they cannot solely rely on a private letter ruling issued to a similarly situated taxpayer.
Gain On Sale – Tax Reporting Requirements
If all gains from the sale of a principal residence are excluded under Section 121, then unless you have received Form 1099-S, no additional reporting is required. For gains exceeding $250,000 (or $500,000 in the case of a joint return), Form 1040 (Schedule D) and Form 8949 should be used. The IRS lays out some of the rules for reporting the sale of your home here, and more detailed information can be found in IRS Publication 523. If you report the sale you should review the IRS Questions and Answers on the Net Investment Income Tax. You can learn more about the Net Investment Income Tax on my blog post here.
Posted November 25, 2021
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