7853 / What special rules apply in calculating the exclusion for gain on the sale of a principal residence?

Editor’s Note: The 2017 tax reform legislation modified the mortgage interest deduction and the deductions for home equity interest and interest on debt related to refinancing. See Q 8032 for details. The treatment of certain mortgage insurance premiums as qualified residence interest was extended through 2021 by CAA 2021 (this treatment expired after 2021). The ability of certain taxpayers to exclude a discharge of qualified principal residence indebtedness from gross income has been extended through 2025.

Property of deceased spouse. For purposes of the exclusion, in the case of a surviving spouse, the period in which the deceased spouse owned and used the property as a principal residence will be attributed to the surviving spouse.¹ The regulations state this rule applies if (1) the taxpayer’s spouse is deceased on the date of the sale of the property; and (2) the taxpayer has not remarried at the time of the sale of the property.² The Service privately ruled that if a surviving spouse who holds a “5 or 5 power” (see Q 824) in a trust sells the personal residence, the gain on the residence will be taxable to the trust as the owner of the corpus, and not the surviving spouse, except to the extent the surviving spouse is treated as the owner of a portion of the property pursuant to a “5 or 5 power.”³

Property owned by former spouse. If property is transferred to the taxpayer by a former spouse pursuant to a divorce decree, the period in which the individual taxpayer owns the property includes the period that the former spouse owned the property. If property is used by a former spouse pursuant to a divorce decree, but is still owned by the taxpayer, the taxpayer is treated, solely for the purposes of this exclusion, as using the property as a principal residence during the use by the former spouse.⁴

Tenant-stockholder in cooperative housing corporation. If a taxpayer is a tenant stockholder in a cooperative housing corporation, the ownership requirement is applied to the holding of the stock, and the use requirement is applied to the house or apartment that the taxpayer is entitled to occupy as a stockholder.⁵ The Service has determined that tenant-stockholders were allowed to exclude $500,000 of gain from the disposition of their shares of stock in their cooperative apartment, which was coordinated with a donation of the same shares to a charitable organization.⁶

Sales of remainder interests. The exclusion applies to gain recognized on the sale or exchange of a remainder interest in a principal residence, provided that the sale or exchange is not to certain related persons; however, the exclusion does not apply to any other interest in such a residence that is sold or exchanged separately.⁷ For the explanation of how to make the election to apply the exclusion to gain from the sale or exchange of a remainder interest, see Treasury Regulation Section 1.121-4(e)(2)(iii). For the rules governing sales or exchanges of partial interests other than remainder interests, see Treasury Regulation Section 1.121-4(e)(1).

Treatment of exclusion in bankruptcy cases. According to the regulations and earlier case law (both of which appear to ignore IRC Section 121(f)), the bankruptcy estate of an individual in a Chapter 7 or Chapter 11 bankruptcy case succeeds to and takes into account the individual’s IRC Section 121 exclusion with respect to the property transferred into the estate if the individual satisfies the requirements of IRC Section 121.⁸

Military Tax Relief

A taxpayer on “qualified official extended duty” in the U.S. Armed Services or the Foreign Service may suspend, for up to 10 years of such duty time, the running of the five-year ownership-and-use period before the sale of a residence. Qualified official extended duty means any “extended duty” (1) while serving at a duty station that is at least 50 miles from the residence, or (2) while residing under government orders in government housing. “Extended duty” means a period of more than 90 days, or for an indefinite period. This election applies to only one property at a time; furthermore, the taxpayer may exclude gain on only one home sale in any two-year period. An election may be revoked at any time.⁹

Mortgage Forgiveness Debt Relief Act of 2007

Under MFDRA 2007, certain discharges of indebtedness on a principal residence have been excludable from gross income, but the date of expiration of this special provision is in doubt.¹⁰ See editor’s note, above.