Cap Gains exclsuion on multiple properties

[tennmike]

Hi so I read some of the other posts but our situation varies slightly from the others I've read where some form of this is possible when 2 spouses own a house prior to being married.  Want to make sure we are maximizing our usage as it pertains to the tax code.

-I purchased home 1 Jan 2018 and lived there until Jan 2021 and rented since. So far I still meet 2 of the last 3 years' requirements, if sold by Jan 2023. Estimated gain if sold: 150k

-Then gf moved in Apr 2020, married Sep 2020 and also lived there until Jan 2021.

-Wife/I purchased home 2 Jan 2021, she is only on the mortgage but we are both on title.  So we will both have to mark it as receiving 50% proceeds?  Estimated gain if sold: 200k

If we sold house 2 this year in 2023 and moved back to house 1 before Jan 2024, could I not take my part of the exclusion to allow for an exclusion in 2024 if house 1 was sold sometime next year?

Do we need to sell house 1 first? She does not meet the requirements for taking the exclusion as she lived there less.  If that's the case, can I take that exclusion and when we sell house 2 she can take 50% and I won't be eligible due to once every 2 years?

What happens if they are sold the same calendar year?

Much appreciated 🙂

[Opus 17]

I don’t think I can address every possible scenario you suggest. Let me give you a couple of clarifying remarks that I notice from your question, and then you can ask any follow ups.

At the present time, you can claim an exclusion on home 1 as long as you sell before January 2024.  Even though you are married, your spouse cannot claim an exclusion on home 1 because she has not lived there for 731 days.  

At the present time, you both qualify to use the exclusion on home 2 if you sell it.  Because you have both lived there since the marriage, and ownership is imparted to both of you by marriage even if both of you were not on the deed, I don’t believe you can split the exclusion. In other words, I don’t think your spouse can claim the $250,000 exclusion when you sell home 2 while you keep your hands clean.

If you sell home 2 and claim the exclusion, then you would not qualify to use any exclusion on home 1 unless you wait at least two years from the date of the previous sale where you used the exclusion.  You could claim a partial exclusion on the sale of home 1 if you sell in less than two years, but only if you sell because of a change in job location, unemployment, or other unforeseeable  financial circumstances that make it impossible for you to keep the home.  In that case, the partial exclusion would be calculated based on how long it had been since you last used the exclusion. For example, if you sell home 2 in January 2024, and then you sell home 1 in July 2024 due to a hardship, you would qualify for an exclusion equal to 25% of the usual limit (6months/24 months); in other words $62,500. Any gain over that would be taxable. 

In addition, renting home 1 out and then moving back into the home creates an unfavorable tax situation called “non-qualified use“. The period of time when you rented the home is not qualified for any exclusion if you move back. The point of the exclusion is to encourage residential home ownership, not reward landlords.  Giving a thorough explanation of non-qualified use would take a long time, but the practical upshot in your case is that if you lived in home 1 for three years, then rented it for three years, then moved back for one year, 3/7 of your gain is non-qualified. You will pay capital gains tax on 3/7 of the gain, and then the remaining 4/7 of the gain is eligible to be covered by your personal $250,000 exclusion. Your spouse would still not qualify to use any part of her exclusion (because she won't have lived there 2 years) unless the reason that you sold the home was due to an unforeseeable financial emergency, which allows a shorter residence time.

You want to start by thinking about where you want to live, why you might want to move, and which home has the larger capital gain.  Deciding where to live based only on the tax position may be unsatisfying for other reasons.  

Your lowest tax situation would be to sell home 1 before January 2024, and then remain in home 2 for at least two more years.  If you sell home 2 and use the full $500,000 exclusion, and move back into home 1, you create an unfavorable situation with home 1 due to the non-qualified use rule, no matter how long you remain living at home 1.

[tennmike]

Thanks for the informative reply Ops 17, I had read some other related posts that you replied to as well around this topic.  Partial exclusions and non-qualified use were the topics I was looking for. I've looked over Pub 523.  Some additional info as regarding unforeseeable financial circumstances, since May we both have been without jobs and are looking to move to a new state for jobs and exiting from both these houses which are close in proximity.

It seems from my understanding we're getting hit with a bit of "marriage tax", had we known about some of these limitations would have done an ROI at the time back in Jan 2021 to compare selling and being free and clear to take new exclusions 2 years later vs keeping it.

If both houses are sold in the same year does it matter on the order they are sold in or can either house be elected to take exclusions on?  If both houses are sold by the end of 2023:

I take full exclusions on home 1 (150/250k) and wife takes her portion on home 2 (100/250k & 0/250k) and taxes are paid on 100k.

We take full exclusions on home 2 (100/250k & 100/250k) and taxes are paid on home 1 on 150k.  Even if unforeseen circumstances qualify, an exclusion is already taken.  Unless it is happens in consecutive years then it is modified by the applicable %.

Furthermore, if this both sales happened in 2024 due to moving back to home 1 the non-qualified use would be applied.  So similar to what you mentioned, let's say its for 6 months (3.5/6.5), then I take full exclusions on home 1 of ~80k and wife takes her portions on home 2 so taxes are paid on ~70k+100k. Plus isn't there some recapture that needs to be included?

Again thanks for your helpful reply!

[Opus 17]

The situation is complicated because I don't know if you can voluntarily split the exclusion of yourself and your spouse for #2.

I think this scenario would work:

You sell home #1 first.  You, but not your spouse qualify to exclude up to $250,000 of gain.  Since the gain is expected to be $150K, you are covered.  Then later, you sell #2.  You are disqualified from using any exclusion because of the 2 year rule since the last exclusion.  Since you are disqualified, but your spouse is not, you can file jointly and your spouse can use their $250,000 exclusion to cover the $200,000 gain.

Also note that in this scenario, if the reason you sell #2 is that you or your spouse find a new job more than 50 miles away (your new commute must be 50 miles longer than your old commute), then your spouse can use their full $250K exclusion and you would qualify for a partial exclusion, even though you had used your full exclusion less than 2 year prior.  Your partial exclusion would be based on the length of time since selling #1.  This might help if the market goes up and your gain is more than expected.

I think this scenario would not be allowed:

You sell home #2 first, and chose to voluntarily only use your spouse's exclusion, even though you both qualify.  Then later, you sell #1 and use your personal $250,000 exclusion.

I don't think this works because I don't think you can voluntarily choose to not apply your exclusion to home #2 if you file a joint return and if you are still allowed an exclusion.  The trick is to disqualify your exclusion on #2 by using it on #1 first.

If you must sell #2 first, your spouse could use her exclusion, and you could decide not to use your exclusion, if you filed married filing separately for that year.  As long as you don't live in a community property state, your wife could treat the entire $200K gain as her taxable income, and claim the exclusion.  You would not include the home at all on your MFS tax return.  However, filing MFS usually results in owing more income tax, because some important deductions and credits are limited or disallowed.  And if you live in a community property state, you must report the income 50/50, meaning you would pay capital gains tax on $100K, so that you could save your exclusion to use on #1 with a gain of $150K. 

If you move back to #1 as your main residence, you are hit with the non-qualified use rule no matter when you move back or how long you live there.

Yes, you also have to recapture your depreciation when you sell #1.

It sounds like you definitely want to sell #2 first and move back to #1, so lets focus on that.

Scenario 1:

Sell #2, file MFJ, and claim the full exclusion ($500K, although your gain is only $200K.  Your gain is tax-free.  Then when you sell #1, you first pay income tax (recapture) on the part of the gain that is due to depreciation you took or should have taken when the home was a rental.  Let's guess that's about $20,000.  Then of the remaining gain ($130K), 53%  ($68,900) is ineligible for the exclusion, so you pay long term capital gains tax.  The other 47% ($61,100) is eligible for the exclusion.  If you don't have a qualified hardship, you pay tax on that too, because you used your exclusion on #2 less than 2 years prior.  So your taxable gain is $130,000 as LTCG and $20,000 as recapture.  If you sell because you took a new job more than 50 miles away, the both spouses can use a partial exclusion, which in this case would be 6 months since the prior sale / 24 months = 25% x $500,000 = $125,000.  Since the partial exclusion is more than the qualified gain, you end up paying tax on $20,000 recapture and $68,900 of non-qualified gain.

Scenario 2:

Sell #2 and file MFS for 2023.  Your spouse reports all the gain (if you are not in a community property state) and used her exclusion.  The gain is tax-free, but you may pay higher income tax due to the difference in tax rates and qualifications for deductions and credits.  Then when you sell #1, you first pay income tax (recapture) on the part of the gain that is due to depreciation you took or should have taken when the home was a rental, we guessed $20,000.  Then of the remaining gain ($130K), 53%  ($68,900) is ineligible for the exclusion, so you pay long term capital gains tax.  The other 47% ($61,100) is covered by your exclusion, because you didn't use it on #2. So you pay income tax on $20,000 recapture and LTCG tax on $68,900 of non-qualified gain.  You don't have to qualify for a hardship in this situation. 

However, if you live in a community property state, then in scenario #2 you must report $100,000 of the gain on your MFS tax return, and if you choose not to use your exclusion, you will pay LTCG tax on that gain.