For many of us, our home is truly our castle. But sometimes we need to change castles. For seniors, a move may be a result of a desire to downsize or move to a warmer climate, or it may be required to meet increased care needs.
Our home may be worth a lot more than we paid for it, especially if we have lived there for a long time. This raises questions regarding the income tax consequences of selling your principal residence.
The news is good. Most seniors will not have to pay income tax when they sell their homes. Here are the basic rules.
Exclusion of Tax on Gain from Sale of Residence
Usually, when you sell an investment that has appreciated in value, you have to pay capital gains tax. But, as a result of tax law changes made in 1997, homeowners can avoid capital gains taxes of up to $250,000 (or $500,000 for couples) when they sell their primary residence. This exclusion is found in federal tax law at 26 USC § 121, which is sometimes referred to as "Section 121."
The amount of gain that is excluded from capital gains tax is also excluded from the new 3.8% Medicare surtax that is imposed on high income taxpayers.
Pennsylvania also allows you to exclude gain from the sale of your residence from state income tax. The Pennsylvania law covering this exclusion is found at 61 PA Code § 103.13(h).
So, the tax law makes your home a privileged investment. On the other hand, as many homeowners have learned over the last few years, if you lose money on the sale of your principal residence you cannot deduct the loss.
To exclude the gain on the sale of your home from tax you must have owned and used the property as your principal residence for two of the five years immediately before the sale. The ownership and use need not be concurrent.
You can generally claim the Section 121 tax exclusion only once every two years. However, a taxpayer who disposes of more than one residence within two years or who otherwise fails to satisfy the requirements due to a job change or a health problem may qualify for a reduced exclusion amount.
IRS regulations interpret Section 121 and answer many questions about how homeowners can qualify for this exclusion, including:
- how to determine if a home is a principal residence;
- when the sale of land that adjoins the residence qualifies for exclusion;
- the circumstances under which sales of fractional interests (such as a joint ownership interest) qualify;
- how a resident of a nursing home or other care facility licensed by the state can qualify for an exception to the requirement that the taxpayer use the home as a principal residence for two of the five years before the sale.
The state regulations differ somewhat from the federal. See the state regulations at 61 PA Code § 103.13(h)
Home Protection Trust Rules Clarified
In a clarification that is important for elder law attorneys and their clients who are seeking to protect their homes from Medicaid Estate Recovery, the regulations state that a residence held in a “grantor trust” qualifies for the capital gains exclusion when sold by the trust. Some elder law attorneys use irrevocable grantor trusts to protect their clients’ homes from nursing home and other long term care costs and related Medicaid Estate Recovery claims.
These trusts are often written as grantor trusts so that a residence transferred to the trust will continue to qualify for favorable income tax treatment, including the Section 121 exclusion.
The federal regulations make it clear that the Settlor of a properly drafted grantor trust remains the owner of a residence for purposes of this tax break, even though the home was irrevocably transferred to the trust to protect it from long term care related costs.
Putting Home in Names of Children can be a Tax Mistake
People sometimes make a serious tax mistake when they retitle their residences in the names of their children. They may be seeking to protect the home from nursing home costs, or inheritance taxes, or probate. But, unless the child resides in the home for the requisite period of the time, the sale of the home can inflict a significant unnecessary capital gains tax on the child. The child will not qualify for the Section 121 exclusion and may end up paying capital gains taxes that could have been avoided.
Seniors are cautioned to consult with an elder law attorney before putting the kids on the title to their homes.