Tax Planning for Establishing Principal Residence Status

By Charles E. Jordan and Stanley J. Clark

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MAY 2005 - IRC section 121 allows a taxpayer to exclude $250,000 ($500,000 for joint filers) of gain on the sale or exchange of a home if it was owned and used as the taxpayer’s principal residence for two of the five years preceding the sale. To qualify for the $500,000 exclusion on joint returns, only one spouse must meet the ownership test, but both spouses must meet the use test. For taxpayers owning two or more residences and alternating their use between them for successive periods of time during the year, determining which home constitutes the principal residence represents a crucial and potentially costly decision. Although the gain exclusion under IRC section 121 became effective on May 6, 1997, definitive guidance on what makes a principal residence arrived more recently in the form of Treasury Regulations in late 2002 and a U.S. district court ruling on April 9, 2003. With real estate prices rising in many areas of the country, substantial gains on home sales have become commonplace in recent years, and proper planning can lead to significant tax savings.

Treasury Regulations

Treasury Regulations section 1.121-1(b)(2) states that when a taxpayer uses more than one residence, the determination of the principal residence depends upon all the facts and circumstances. If a taxpayer alternates between two homes and uses each one as a residence, the principal residence would generally be the one the taxpayer uses the majority of the time during the year. For example, assume H and W are married taxpayers who own two homes, one in Ohio and the other in Florida, for five years (2000 through 2004), and spend 30 weeks each year in the Ohio home and 22 weeks each year in the Florida home. The home in Ohio typically would be considered the principal residence because it is used for the majority of the year. Selling the Florida home would not result in gain exclusion, while selling the Ohio home would.

Careful tax planning in this example could have resulted in either home qualifying for the gain exclusion. For example, assume the same facts as above except that H and W used the Florida home for 30 weeks and the Ohio home for 22 weeks each year during 2003 and 2004. In this case, the Ohio home would have been the principal residence in 2000, 2001, and 2002, while the Florida home would have been the principal residence in 2003 and 2004. Selling either home (but not both) in 2005 would result in gain exclusion because each home would have been the principal residence for at least two of the five years prior to the sale. The regulations do not specify what constitutes a “majority of the year,” but a literal interpretation suggests that 183 days or more would qualify.

The regulations take a holistic approach to determining the principal residence when a taxpayer alternates between properties. In addition to considering the amount of time the property was used during the year, other relevant factors include, but are not limited to, the following:

  • The taxpayer’s place of employment;
  • The principal place of abode of the taxpayer’s family members;
  • The address listed on the taxpayer’s federal and state tax returns, driver’s license, automobile registration, and voter registration;
  • The taxpayer’s mailing address for bills and correspondence;
  • The location of the taxpayer’s banks; and
  • The location of the taxpayer’s religious organizations and recreational clubs.

The above factors are not all-inclusive. Another relevant factor might be the location at which the taxpayer claims the homestead exemption for local property taxes. Amounts paid for utility bills (e.g., water, electricity, gas, telephone, etc.) might also help establish which home is the principal residence. Some of the above factors, such as the place of employment and the location of taxpayer’s family members, are rigid and not easily affected by tax planning. For others, though, tax planning can help in ambiguous cases.

Judicial Guidance

The most significant case to date on determining principal residence status when multiple residences exist is a 2003 U.S. district court case in Arizona (Guinan v. U.S., 2003-1 USTC para. 50475). On September 15, 1998, James and Jean Guinan sold a residence in Wisconsin they had owned for five and a half years. The couple also owned a home in Georgia until they sold it in 1996, at which time they bought a home in Arizona. During the five years prior to the sale of the Wisconsin home, the couple alternated use between the Wisconsin home in the warm months and the Georgia or Arizona home in the cold months. The Guinans originally reported the gain on the sale of their Wisconsin residence on their 1998 federal income tax return, but later filed an amended return requesting a refund for approximately $45,000, claiming that the Wisconsin home had been their principal residence. The IRS denied the request, and the case went to the Arizona District Court.

Using a holistic approach and the factors outlined in Treasury Regulations section 1.121-1(b)(2), the court found that the Wisconsin home did not appear to be the Guinans’ principal residence for at least two of the five years prior to the sale. During the five years prior to the sale of the Wisconsin home, they spent the majority of the time in this residence for only the first year (1993/94). For the remaining four years, they spent the majority of each year at the Georgia or Arizona home.

The court noted that, although use (i.e., time spent in the residence) was probably the most important factor in determining the Guinans’ principal residence, the other factors in the regulations were also considered.

During the five years prior to the sale, the couple had bank accounts and received mail at each residence. They engaged in recreational activities at all locations. Although the couple kept a vehicle and two boats in Wisconsin, they also kept two vehicles at their Georgia or Arizona residence. None of the Guinans’ children lived in Wisconsin, Georgia, or Arizona. The above factors provided no indication concerning which home represented the principal residence. Other factors, though, clearly suggested that the Wisconsin home was not the principal residence. For example, during the five-year period in question, the couple filed no Wisconsin state tax returns but filed state returns in Georgia or Arizona. In addition, neither taxpayer was registered to vote in Wisconsin nor carried a Wisconsin driver’s license. Conversely, both spouses were registered to vote and had a driver’s license first in Georgia and then in Arizona. Only one factor—its imposing size—plainly favored the Wisconsin home as the principal residence. The court ruled, however, that this one factor alone was insufficient.

Tax Planning Strategies

For taxpayers that alternate time between two residences during the year, some planning strategies can be gleaned from the regulations and the case above. Both the regulations and the judgment indicate that the most important single factor in determining principal residence status is usage or time in residence during the year. For taxpayers such as the Guinans, care should be taken to ensure that the residence with the largest potential gain, or the one most likely to be sold, is used for the majority of the year for at least two years. In the Guinans’ case, if the taxpayers had used their Wisconsin residence for just 10 days more in either of two years, they would have met the use test and had a stronger case.

The Guinans could also have strengthened their position by using Wisconsin banks, filing federal tax returns using the Wisconsin address, and obtaining Wisconsin driver’s licenses and vehicle registrations. Having bills mailed to the Wisconsin address and participating in religious organizations would also have helped. All of these factors were under the taxpayers’ control.

As noted above, both spouses must meet the use test to qualify for the full $500,000 gain exclusion. Joint filers not meeting this requirement can still claim a gain exclusion equal to the sum of each taxpayer’s limitation, determined on a separate basis as if they were not married. The Guinans might have been able to use a $250,000 gain exclusion if either spouse had lived in the Wisconsin residence for just a few days longer in one of the two years in which they were close to meeting the use test.

This is another example where some prudent tax planning would have satisfied the letter and intent of the tax law and provided for significant tax savings as well.


Charles E. Jordan, DBA, CPA, and Stanley J. Clark, PhD, CPA, are professors in the School of Accountancy and Information Systems, College of Business and Economic Development, University of Southern Mississippi, Hattiesburg, Miss.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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