To buy or to rent? This is a difficult question with no single answer. The decision to purchase a home is a significant one that includes both nontax and tax considerations.
Primary nontax factors favoring home ownership include the home’s potential to appreciate as an investment. As the value of the home increases, so does the home- owner’s net worth.
A home is frequently an individual’s most significant investment. Therefore, home ownership also carries significant potential risk. When real estate values decline, the
THE KEY FACTS Tax and Nontax Consequences of Home
Ownership
• Nontax consequences
• Large investment.
• Potential for big return (or loss) on investment with use of leverage.
• Risk of default on home loan.
• Time and costs of maintenance.
• Limited mobility.
• Tax consequences
• Deductible interest expense.
• Excludable gain on sale.
• Deductible real property taxes on home.
• Rental and business-use possibilities.
owner’s net worth also declines. Homeowners borrowing funds to purchase their home have the potential to achieve high returns on their cash investment due to the power of leverage (the homeowner provides the down payment and the bank provides the rest of the cash to purchase the home), but a home is by no means a liquid asset. Furthermore, homeowners must assume the risk associated with the possible default on the loan. If the owner does not make the mortgage payments required by the terms of the loan, the lender may repossess the home. Homeowners also are responsible for the cost or effort required to repair, maintain, and landscape the home. Finally, because building, buy- ing, selling, and moving in or out of a home are expensive and time-consuming tasks, home ownership reduces the ability to relocate to take advantage of new opportunities.
On the tax side, the government clearly smiles on home ownership, given the deduc- tions available to homeowners that are unavailable to renters. In fact, the deductibility of mortgage interest on owner-occupied homes has historically been ranked in the top ten on the government’s list of projected “tax expenditures” (tax breaks provided to taxpayers).
Besides the deduction for interest payments made on home mortgages, other tax benefits of home ownership include the deduction of real estate taxes paid on the home, the exclu- sion of gain on the sale of the home, and the deduction of expenses relating to business offices in the home. Homeowners also may gain tax benefits associated with owning and renting a vacation home. We address the tax consequences of home ownership through- out this chapter.
Exclusion of Gain on Sale of Personal Residence
When a taxpayer sells a personal residence, she realizes a gain or a loss calculated by subtracting the basis of the home from the amount she receives from the buyer (minus selling costs). The basis of the residence depends on how the taxpayer acquired the home.
The general rules for determining the basis of the home are as follows:
∙ Purchase: the cost of the home.
∙ Inheritance: the fair market value of the home on the date of the decedent’s death.
∙ Gift: the donor’s basis.
∙ Conversion of rental home to residence: the taxpayer’s basis in the rental home at the time of the conversion.
Because a personal residence is a capital asset, the gain a taxpayer recognizes by selling the residence is a capital gain. However, because a personal residence is also a personal- use asset, the loss on the sale of a personal residence is a nondeductible personal loss.4 This is an important limitation for many taxpayers when the housing market is depressed.
When a taxpayer sells a personal residence at a gain, the tax consequences are generally more favorable. In fact, taxpayers meeting certain requirements are allowed to exclude a certain amount of realized gain on the sale.5 The maximum exclusion depends on filing status as follows:
∙ $500,000 for married filing jointly taxpayers.
∙ $250,000 for other taxpayers.
Gain in excess of the excludable amount generally qualifies as long-term capital gain subject to tax at preferential rates. Further, gain in excess of the exclusion amount is con- sidered to be investment income for purposes of determining the 3.8 percent net invest- ment income tax discussed in the Individual Income Tax Computation and Tax Credits chapter.
LO 14-2
4§165(c).
5Prior to 2018, taxpayers were allowed to exclude gain they realized on debt forgiveness when a lender foreclosed on their home. This provision had not been extended to 2018 as of the time we went to press.
Requirements To qualify for the exclusion, the taxpayer must meet both ownership and use tests for the residence:
Ownership test: The taxpayer must have owned the property for a total of two or more years during the five-year period ending on the date of the sale. The owner- ship test prevents a taxpayer from purchasing a home, fixing it up, and soon there- after selling it and excluding the gain—a real estate investment practice termed flipping. In these circumstances, the gain is primarily due to the taxpayer’s efforts in remodeling the home, not to general appreciation in the value of the property.
Use test: The taxpayer must have used the property as her principal residence (see earlier discussion) for a total of two or more years during the five-year period end- ing on the date of the sale. The exclusion provision was designed to provide tax benefits to homeowners rather than investors or landlords. The use test helps ensure that taxpayers using the exclusion have realized gains from selling the home they actually lived in as opposed to selling an investment or rental property.
Note that the periods of ownership and use need not be continuous, nor do they need to cover the same two-year period. In fact, a taxpayer could rent a home and live in it as her principal residence during 2013 and then again during 2015, purchase the home and rent it to someone else during 2016 and 2017, and then sell the home at the beginning of 2018—and still meet the ownership and use tests!
Example 14-1
The Jeffersons sold their home in Denver, Colorado, before moving to Chicago. They sold the Denver home for $450,000. The Jeffersons initially purchased the home for $350,000. They owned and lived in the home (as their principal residence) for four years before selling. How much of the $100,000 gain realized on the sale ($450,000 − $350,000) are they allowed to exclude?
Answer: All $100,000. The Jeffersons qualified for the full exclusion available to married couples fil- ing jointly because they met the ownership and use tests. Consequently, they are allowed to exclude the entire $100,000 of gain and could have excluded up to $500,000 of gain on the sale.
Example 14-2
What if: Suppose that when Tyler and Jasmine were married, Jasmine moved into Tyler’s home located in Denver, Colorado. Tyler had purchased the home two years before the marriage. After the marriage, the couple lived in the home together as their principal residence for four years before sell- ing the home and moving to Chicago. Tyler was the sole owner of the home for the entire six years he resided in the home. Would gain on the sale of the home qualify for the $500,000 exclusion available to married couples filing jointly even though Jasmine was never an owner of the home?
Answer: Yes. Gain on the sale qualifies for the full $500,000 exclusion available to married couples filing jointly because Tyler has met the ownership test, and both Tyler and Jasmine have met the use test.
What if: Suppose that Tyler and Jasmine lived in the home together for only one year before selling it. Would the couple be allowed to exclude any gain on the sale?
Answer: Yes, however, because Jasmine does not meet the use test, they would qualify only for the
$250,000 exclusion even if they were to file a joint return.
How do the ownership and use tests apply to married couples filing joint returns?
Married couples filing joint returns are eligible for the full $500,000 exclusion if either spouse meets the ownership test and both spouses meet the principal-use test. However, if either spouse meets the ownership test but only one spouse meets the principal-use test, the couple’s exclusion is limited to $250,000 on the couple’s joint tax return.
If a widow or widower sells a home that he or she owned and occupied with the decedent spouse (the spouse who died), the surviving spouse is entitled to the full
$500,000 exclusion provided he or she sells the home within two years after the date of death of the spouse. Finally, once a taxpayer claims a home sale exclusion, she is not eligible to claim another exclusion until at least two years pass from the time of
THE KEY FACTS Exclusion of Gain on
Sale of Personal Residence
• Must meet ownership and use tests.
• Must own home for at least two of five years before sale.
• Must use home as prin- cipal residence for at least two of five years before sale.
• For married couples to qualify for maximum ex- clusion on a joint return, one spouse must meet the ownership test and both spouses must meet the use test.
the first sale (see the unforeseen circumstances discussion for an exception to this general rule).
General rule exceptions for nonqualified use, unforeseen circumstances and depreciation.
In certain circumstances, taxpayers who otherwise meet the ownership and use require- ments may have their exclusion limited under a “nonqualified use” provision. In other circumstances, taxpayers who fail the ownership and/or use tests are allowed to exclude gain on the sale of their residence under an “unforeseen” circumstances provision. Fi- nally, taxpayers who have claimed depreciation deductions on their home for rental or business use (see discussion later in the chapter) may be required to recognize gain on the sale of their residence that otherwise would have been excluded. Let’s first discuss the nonqualified use provision.
Under the general rules for the home sale exclusion, taxpayers could exclude gain on the sale of a vacation home or rental property (including gain accrued while it was not a principal residence) simply by moving into the property and using it as their principal residence for two years before selling it. To limit a taxpayer’s ability to benefit from this strategy, the nonqualified use provision reduces the taxpayer’s otherwise excludable gain on the home sale if, on or after January 1, 2009, the taxpayer used or uses the home for something other than a principal residence (termed nonqualified use).6 The period of nonqualified use does not include any portion of the five-year period ending on the date of the sale that is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse. This exception allows the taxpayer time to sell the principal residence after moving out of it without having to count the time the house is available for sale as nonqualified use (if it were considered to be nonqualified use, the amount of gain the taxpayer would be eligible to exclude would be reduced).
If the nonqualified use limitation applies, the percentage of the realized gain that must be recognized is the ratio of the period of nonqualified use divided by the period of time the taxpayer owned the home (acquisition date through date of sale). Note that this provision does not reduce the maximum exclusion; it reduces the amount of realized gain eligible for exclusion.
6§121(b)(5).
What if: Suppose the Jeffersons purchased home 1 on January 1, 2015, for $350,000. They lived in home 1 as their principal residence until January 1, 2018, when they moved into a new principal resi- dence (home 2). They finally sold home 1 on January 1, 2020, for $450,000. What amount of the
$100,000 gain on the sale of home 1 ($450,000 amount realized minus $350,000 basis) may the Jeffersons exclude from gross income?
Answer: All $100,000. The Jeffersons meet the ownership and use tests (they owned and used home 1 as their principal residence for at least two of the five years prior to January 1, 2020), so they qualify for a maximum exclusion of $500,000. Further, the gain eligible for the exclusion is not reduced because the Jeffersons stopped using home 1 as a principal residence after January 1, 2018, and they sold the home within five years of this date.
What if: Assume the same facts as above, except that on January 1, 2019, the Jeffersons moved back into home 1 and used it as their principal residence until they sold it for $450,000 on January 1, 2020.
What amount of the $100,000 gain on the sale of home 1 may the Jeffersons exclude from income?
Answer: $80,000. The Jeffersons meet the ownership and use tests for home 1 and therefore qualify for the maximum potential $500,000 exclusion. However, because they stopped using the home as their principal residence for a period on or after January 1, 2009 (nonqualified use from January 1, 2018–January 1, 2019), and they used the home as their principal residence immediately before sell- ing (January 1, 2019–January 1, 2020), the gain eligible for exclusion must be reduced. The percent- age of the gain that is not eligible for exclusion is 20 percent, which is the period of nonqualified use (one year: January 1, 2019–January 1, 2020) divided by the total period of time the Jeffersons owned the home (five years: January 1, 2015–January 1, 2020). Therefore, the Jeffersons must reduce their gain eligible for exclusion by $20,000 ($100,000 gain × 20% reduction percentage), allowing them to exclude $80,000 of the $100,000 gain from gross income.
Example 14-3
Sometimes taxpayers are unable to meet the two-year requirements for the ownership and use tests due to unforeseen circumstances. For example, a taxpayer may be forced to sell his home before he meets the ownership and use requirements due to a change in employment, significant health issues, or other unforeseen financial difficulties.7 In such cases, the maximum exclusion amount ($500,000 for married filing jointly, $250,000 oth- erwise) is reduced based on the amount of time the taxpayer owned and used the home as a principal residence before selling. For example, if a single taxpayer owned and used a home as a principal residence for six months before selling due to unforeseen circum- stances, the maximum exclusion would be $62,500, which is one-fourth of what it would be otherwise (6 months of ownership and use divided by 24 months required under the general rule, multiplied by the full $250,000 exclusion for single taxpayers). The maxi- mum exclusion available to a taxpayer selling under these circumstances is expressed in the formula presented in Exhibit 14-2.
7The IRS recently ruled that a couple’s need to move because of a birth of a second child was an unforeseen circumstance (LTR 201628002).
8Taxpayers may choose to use the number of days the taxpayer fully qualified for the exclusion divided by 730 days. See Reg §1.121-3(g).
THE KEY FACTS Exclusion of Gain on
Sale of Personal Residence
• Exclusion amount
• $500,000 for married couples filing joint returns.
• $250,000 for other taxpayers.
• Gain eligible for exclu- sion may be reduced for a period of nonqualified use.
• Unforeseen circum- stances provision maxi- mum exclusion = Full exclusion × Months of qualifying ownership and use/24 months.
Example 14-4
What if: Let’s assume that when the Jeffersons moved from Denver, they purchased a home in Chicago for $375,000 and moved into the home on July 1, 2017. In January of 2018, Tyler accepted a work opportunity with a different employer located in Miami, Florida. On February 1, 2018, the Jeffersons sold their home for $395,000 and permanently relocated to Miami. How much of the $20,000 realized gain ($395,000 − $375,000) on their Chicago home sale can the Jeffersons exclude from taxable income?
Answer: All $20,000. The Jeffersons lived in the home for only seven months (July 1, 2017, to February 1, 2018), so they do not meet either the ownership or the use test to qualify for the maxi- mum exclusion. However, under the unforeseen circumstances provision, they are eligible for a re- duced maximum exclusion computed as follows: $500,000 (maximum exclusion) × 7 (qualifying months)/24 = $145,833. Because the amount they are able to exclude ($145,833) exceeds the
$20,000 gain they realized on the sale, they are able to exclude all $20,000.
What if: Assume the same facts, except that the Jeffersons realized a $150,000 gain on the sale of their home. How much of the realized gain would they recognize and at what rate would this gain be taxed?
Answer: $150,000 gain realized minus $145,833 exclusion = $4,167 short-term capital gain (the home is a capital asset that the Jeffersons owned for one year or less). Assuming the Jeffersons did not recognize any other capital gains during the year, the $4,167 would be taxed at the Jeffersons’
32 percent marginal tax rate (see storyline summary at beginning of chapter).
Note, as the previous example illustrates, that under the so-called unforeseen circum- stances provision, it is the full exclusion that is reduced, not necessarily the excludable gain. Consequently, if a taxpayer’s gain on the sale of a residence is less than the maximum EXHIBIT 14-2 Formula for Determining Maximum Home Sale Exclusion
in Unforeseen Circumstances
Maximum exclusion in unforeseen circumstances = Full exclusion × Qualifying months/24 months, where
Full exclusion = $250,000 for single taxpayers or $500,000 for taxpayers filing a joint return.
Qualifying months = the number of months the taxpayer met the ownership and use requirements for the home before selling it.
24 months = the number of months the taxpayer must own and use the home as a principal residence to qualify for the full exclusion.8
Source: See Reg §1.121-3(g).
exclusion (after the unforseen circumstances adjustment), the taxpayer may exclude the entire amount of the gain.
Finally, taxpayers who used their home for business purposes (home office expense) or rental purposes are not allowed to exclude gain attributable to depreciation deductions incurred after May 6, 1997. Rather, this gain is treated as unrecaptured §1250 gain and is subject to a maximum 25 percent tax rate (see the Investments chapter for a detailed discussion of unrecaptured §1250 gain).
Home Mortgage Interest Deduction
A primary tax benefit of owning a home is that taxpayers are generally allowed to de- duct the interest they pay on their home mortgage loans as an itemized deduction. Tax- payers generate tax savings and reduce the after-tax cost of their mortgage payments to the extent of their deductible interest payments. However, because the recently enacted tax law nearly doubled the standard deduction for years after 2017, fewer taxpayers are likely to itemize deductions and benefit from deducting home mortgage interest and those that do benefit only to the extent that mortgage interest exceeds the standard deduction (when added to other itemized deductions). Nevertheless, taxpayers with sig- nificant nonmortgage interest itemized deductions (e.g., charitable contributions, state income taxes, and real property taxes) can generate substantial tax savings from the home mortgage interest deduction.
LO 14-3
During the current year, Tyler and Jasmine own a home with an average mortgage balance of
$400,000. They pay interest at 5 percent annually on the loan, and they qualify to deduct the interest expense as an itemized deduction. The Jeffersons’ marginal income tax rate is 32 percent, and before counting mortgage interest, their itemized deductions exceed the standard deduction. What is the before- and after-tax cost of their mortgage interest expense for the year?
Answer: $20,000 before-tax cost and $13,600 after-tax cost, computed as follows:
Description Amount Explanation
(1) Before-tax interest expense $ 20,000 $400,000 × 5% (all deductible)
(2) Marginal tax rate × 32%
(3) Tax savings from interest expense 6,400 (1) × (2) After-tax cost of interest expense $13,600 (1) − (3)
Note that the $6,400 tax savings generated by the mortgage interest expense deduction reduces the after-tax cost of their monthly mortgage payment by $533 ($6,400/12).
What if: Assume the original facts except that before counting the mortgage interest expense, the Jeffersons’ itemized deductions were $6,000 below the standard deduction. How much tax savings would the $20,000 mortgage interest expense generate for the Jeffersons?
Answer: $4,480. ($14,000 × 32%). The first $6,000 of mortgage interest expense increases the Jeffersons’ itemized deductions to equal the standard deduction but does not affect their taxable income. The remaining $14,000 increases itemized deductions above the standard deduction and thus reduces taxable income, producing tax savings.
What if: Assume that instead of buying a home, the Jeffersons rented a home and paid $1,667 a month for rent expense. What would be the before- and after-tax cost of the $20,000 annual rental payments?
Answer: $20,000 before-tax cost and $20,000 after-tax cost. Because rental payments are not de- ductible, they do not generate tax savings, so the before- and after-tax cost of the rental payments is the same.
Despite the apparent tax savings from buying versus renting a home, it is important to consider that nontax factors could favor renting over purchasing a home.
Example 14-5