Richard C. Watson III, JD, MSFS, CFP®, ChFC®, CLU®, EA
Clients own multiple residences for a variety of reasons. For many affluent retirees, the lure of warmer weather in the winter or cooler weather in the summer has always been an enticement to buy a second residence. The tax code has provided further leverage to enable this strategy, since mortgage interest is deductible on up to two qualified residences.1 Other clients may have inherited property and began using it as a second residence, entered marriage already owning a home, or purposely converted rental property into a second residence.
After a steady real estate boom, many clients owning multiple residences over the past ten years have experienced significant appreciation. Now, as the real estate market has begun to soften in many parts of the country, clients contemplating selling one or more of their residences feel that they cannot for fear of the heavy tax consequences. This article addresses the tax impact of such a scenario.
Excluding Gain from the Sale of a Residence
Internal Revenue Code § 121 provides that a taxpayer can exclude up to $250,000 ($500,000 if married filing jointly) of realized gain from the sale of a principal residence. To qualify for this treatment, however, the taxpayer must have owned and occupied the residence as a "principal residence" for periods aggregating two years or more during the five years preceding the sale of the home.2
But what if you have clients who actually split their time between two residences, such that part of their year is spent in, say, Newport Beach, California, and the other part of their year is spent in, say, Camden, Maine? Which residence qualifies for an IRC § 121 exclusion as a primary residence upon a subsequent sale?
Clients with Two or More Primary Residences
In a Private Letter Ruling last year 3, the Internal Revenue Service indicated that if a client uses more than one property as a primary residence, the one that qualifies as the "principal residence," under IRC § 121(a), depends on a two-prong test.
First, the client must use the residence as a principal residence, which is largely based on a facts and circumstances test.4
According to Treasury Regulation 1.121-1(b)(2), several factors the IRS evaluates to help determine this part of the test include the following:
- The time spent in a residence
- 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 card
- The taxpayer's mailing address for bills and correspondence
- The location of the taxpayer's banks
- The location of religious organizations and recreational clubs with which the taxpayer is affiliated
Secondly, after the client's principal residence has been determined, the number of days that the client actually occupied the residence is added up to determine if the client has met the two year statutory requirement.
Example of the Two-prong Test in Action: Guinan v. United States
While the residence the client uses the majority of time during the year will be considered a major factor, the leading case in this area, Guinan v. United States, held that it was not the most important factor.5
In that case, the taxpayer's owned and used primary residences in Wisconsin, Georgia, and Arizona. After selling their Wisconsin residence, they sought to exclude the gain realized on the sale, relying on the argument that, because they had spent more time in their Wisconsin home relative to their Georgia or Arizona homes, it was their principal residence for IRC § 121 purposes.6
The following table breaks down the number of days the taxpayers actually occupied each residence over a five-year period, prior to the sale of their Wisconsin residence in Year 5 below:
As the above table illustrates, it was undisputed that the taxpayers spent more days in their Wisconsin residence than in their Georgia or Arizona residences.
However, the court held that this was not solely determinative for IRC § 121 purposes, citing several of the above Reg. 1.121-1(b)(2) factors that indicated the taxpayer did not have a principal residence, including, for example, the fact that the taxpayer had not filed a Wisconsin state income tax return, had not registered to vote in Wisconsin, nor had a valid Wisconsin driver's license.
As a consequence, the court denied the taxpayers IRC § 121 treatment for the sale of their Wisconsin residence, and they were not permitted to exclude any of the realized gain.
Lessons Learned from Guinan
So what should you advise a client with two or more primary residences to do, provided they hope to use IRC § 121 to exclude part or all of the realized gain on the sale of one (or potentially multiple) residences over a given period of time?
Depending on the history of the property (i.e., if it was inherited, rental, or vacation property), the first step is to treat and use the residence they want to sell as their principal residence for the statutory period (i.e., for periods aggregating two years or more out of the five years preceding the sale).
From there, the client can strengthen their claim further by (legitimately) demonstrating as many of the Reg. 1.121-1(b)(2) factors as possible.
For example, assume our clients split time at primary residences in Camden, Maine and Newport Beach, California, but now want to sell their Newport Beach residence, so as to completely relocate to Camden for retirement. Because they have owned and used both residences for well over five years, either residence appears to meet the statutory period requirement.
Our clients would want to consider maintaining a California or local banking arrangement, registering to vote in California, obtaining a California driver's license, registering their vehicle(s) with the California DMV, paying California state income taxes, and/or documenting their regular attendance and participation in a religious organization or recreational club in California, if appropriate, prior to the sale.
The idea is to have more Reg. 1.121-1(b)(2) factors favoring Newport Beach than Camden, because it will likely be impossible to have all of these factors perfectly align with one residence or another, particularly factors such as where other family members happen to reside or where a client has recently been employed. It should be noted that this does not necessarily mean that our clients can not spend time in their Camden residence in the year of the Newport Beach sale, merely that they should plan to reside for more days in Newport Beach than in Camden in the year of the sale.
As a result, with careful IRC § 121 tax planning, our clients should not have an issue with excluding up to $500,000 of realized gain on the sale of their Newport Beach residence, assuming their filing status is married filing jointly.
In theory, they would also be eligible for another IRC § 121 exclusion on their Camden residence, if they sought to sell that residence in the future, provided they could now meet the two-prong test for this property. Since they have already met the statutory period requirement, particular emphasis and planning for the Reg. 1.121-1(b)(2) factors would likely be required.
Planning for intrastate residence sales should be somewhat easier to argue than interstate sales, as in Guinan, because many of the Reg. 1.121-1(b)(2) factors will already be in place for some intrastate sales. For example, if our clients owned and used residences in Newport Beach and Big Bear, California, rather than having a second residence in Maine, but still wanted to sell the Newport Beach house in order to live permanently in Big Bear, they would likely already have many of the Reg. 1.121-1(b)(2) factors in place, since both locations are only about two hours apart.
Finally, as Guinan demonstrates, IRC § 121 planning can be complex. Since clients bear the burden of proving that their particular residence is their principal residence during a given time period7, it is incumbent on us to advise our clients to begin tax planning for the residence they want to sell well in advance of the sale itself and to include their CPA or tax advisor in the process as early as possible.
Richard C. Watson III, JD, MSFS, CFP®,
ChFC®, CLU®, EA, is the managing partner of
Torres & Watson, an independent financial advisory practice of
Ameriprise Financial. His planning experience includes advanced
estate planning, income taxation (particularly for clients subject
to the alternative minimum tax), executive compensation (including
non-qualified deferred compensation arrangements), and tax aware
investment management issues. He can be reached at email@example.com
- IRC § 163(h)(4)(A). Property taxes are deductible under Reg. 1.164-4(a)
- IRC § 121(a)
- PLR 200645001
- Reg. § 1.121-1(b)(1)
- Guinan v United States (2003, DC Ariz) 2003-1 USTC P 50475, 91 AFTR 2d 2174
- The Guinans paid the income taxes on the gain realized from their Wisconsin residence in 1998 and then filed an amended return in 2001, seeking a refund of $45,009 of income taxes paid.
- Rockwell v C.I.R., 512 F.2d 882, 887 (9th Cir. 1975); Pipitone v United States, 180 F.3d 859, 862 (7th Cir. 1999)