| || Example. H bought a house in 2015. On January 1, 2019, H&W marry, and W moves in. The house remains in H's name only. The house is sold in 2021. The full $500,000 exclusion is available, because H passes the ownership test, and both H&W pass the use test. |
But what if W had only moved in ONE year before the sale, and thus didn't satisfy the use test. Would H&W lose the entire exclusion? Reg. Section 1.121-2(a)(3) provides a bail out by stating that if one spouse doesn't pass the use test, we determine each spouse's limitation separately as if they were single, and then combine the amounts. For these purposes, each spouse is treated as having owned the property for the period of the other spouse's ownership.
Example 2. H bought a house in 2015. On January 1, 2020, H&W marry, and W moves in. The house remains in H's name only. The house is sold in 2021. Here, W doesn't pass the use test, because she did not live in the home for two years prior to sale. As a result, the exclusion is determined separately: if H were single, he would be entitled to a $250,000 exclusion because he passed both the ownership and use test. If W were single, while she would be attributed H's period of ownership, because she only used the home for one year, she would be ineligible for any exclusion (unless the sale was caused by unforeseen circumstances as discussed below). Thus, the total exclusion is $250,000.
Next, Reg. Section 1.121-4 provides that if a spouse dies, the surviving spouse is treated as owning and using the home for the entire time the deceased spouse owned and used the property. This rule only applies, however, if the spouse doesn't remarry before the sale.
Example 3. H bought a house in 2015. On January 1, 2020, H&W marry, and W moves in. The house remains in H's name only. H dies on December 31, 2020. W inherits the house, and sells it in 2021. Here, W doesn't pass the ownership or use test on her own, but by virtue of the regulations allowing her to tack on H's ownership and use, she meets both tests and may exclude $250,000 of gain. Interestingly, if W had satisfied the use test on her own prior to H's death, a sale of the property within two years of H's death would give W a full $500,000 exclusion pursuant to Section 121(b)(4).
Another common scenario involves a house that is transferred from one spouse to another upon divorce under Section 1041, and is then immediately sold before the transferee spouse has met the two-year ownership test. In this case, Reg. 1.121-4(b)(1) treats the transferee spouse as if they owned the property for the period it was owned by the transferor spouse.
Example 4. H bought a house in 2015. On January 1, 2019, H&W marry, and W moves in. The house remains in H's name only. H&W divorce on December 31, 2020, and H transfers the home to W during 2021 in a transaction governed by Section 1041. W sells the home on December 31, 2021. Despite the fact that W only owned the house for a few months in 2021, because W received the property in a Section 1041 transfer pursuant to divorce, W is treated as having owned the property for the entire period it was owned by H. In addition, W has used the property for more than two years. As a result, W gets a $250,000 exclusion.
Finally, it's important to understand that in some cases, you can fail BOTH the ownership and use test and still get a reduced exclusion. Reg. 1.121-3 provides that if you are forced to sell your home before the two-year ownership and use tests are met because of a change of employment, health, or "unforeseen circumstances," you can claim a prorated exclusion equal to the full exclusion (depending on filing status), multiplied by the number of months you owned and used the home, divided by 24.
Example 5. A purchased a home in Colorado as his principal residence on January 1, 2020. On January 1, 2021, his employer transferred him to New Jersey, and he was forced to sell his home. On June 30, 2021, the home was sold. A may exclude $187,500 of gain ($250,000 * 18 months /24 months).
There are a few more nuances to Section 121 -- military moves, nonqualified use as a rental property, home office depreciation, etc...-- but this should be enough to help you out of most sticky situations and save family, friends and clients real money.