Hardship and 2 of 5 rule

[k2kennedy]

In 2019 we purchased a home at the beach (80 miles away) that we plan to sell in 2023 and then move out of state in 2024. This home was our main residence during the pandemic and continues to be during summers. All in all we will have lived in the home 18 months in the past five years. My husband is changing office locations in 2024 (same employer). My husband experienced a $100K pay cut this year while the house was his main residence. My questions...do we qualify for a hardship exclusion to the 2 of 5 rule on the basis of 1) a significant pay cut or 2) a job location change? To be clear we plan to sell the house and then buy out of state so there will be a 6-9 month lag between the sale and when we actually are able to move. Also are there rules around timing of the hardship and sale date? We have a $300K gain so want to minimize capital gains tax and are close to meeting the 2 of 5 rule. We could also plan to live in this home another six months and qualify but are nervous about the housing market.

[MonikaK1]

There are specific circumstances in which you can claim a hardship exclusion to the 2 out of 5-year residency rule, in order to receive a partial exclusion of gain, and yes, they involve the timing of the hardship.

There are many facts and circumstances to consider in this scenario. Consider carefully whether you have met the requirements before excluding the gain, and be prepared to present your case in the event of an IRS audit.

Please see IRS Publication 523 for a detailed explanation of the requirements. Here are some relevant excerpts:

Determine whether you meet the residence requirement.

If you owned the home and used it as your residence for at least 24 months of the previous 5 years (leading up to the date of sale), you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period, and it doesn't have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period. Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion.

If you were ever away from home,

you need to determine whether that time counts toward your residence requirement. A vacation or other short absence counts as time you lived at home (even if you rented out your home while you were gone).

If you become physically or mentally unable to care for yourself,

and you use the residence as your principal residence for 12 months in the 5 years preceding the sale or exchange, any time you spent living in a care facility (such as a nursing home) counts toward your 2-year residence requirement, so long as the facility has a license from a state or other political entity to care for people with your condition.

If you don't meet the Eligibility Test, you may still qualify for a partial exclusion of gain (see the section Does Your Home Qualify for a Partial Exclusion of Gain?). You can meet the requirements for a partial exclusion if the main reason for your home sale was a change in workplace location, a health issue, or an unforeseeable event.

[k2kennedy]

Thank you! I can't find how much time is allowed between the hardship occurring and my closing date? Can I sell before my husbands actual job move date?

[MonikaK1]

In order for a work-related move to meet the requirements for partial exclusion, any of the following events needs to have occurred during your time of ownership and residence in the home:

• You took or were transferred to a new job in a work location at least 50 miles farther from the home than your old work location. For example, your old work location was 15 miles from the home and your new work location is 65 miles from the home.
• You had no previous work location and you began a new job at least 50 miles from the home.
• Either of the above is true of your spouse, a co-owner of the home, or anyone else for whom the home was his or her residence.

Even if your situation doesn’t match any of the standard requirements described above, you still may qualify for an exception. You may qualify if you can demonstrate the primary reason for the sale, based on facts and circumstances, is work-related, health-related, or unforeseeable. Important factors are:

• The situation causing the sale arose during the time you owned and used your property as your residence.
• You sold your home not long after the situation arose.
• You couldn’t have reasonably anticipated the situation when you bought the home.
• You began to experience significant financial difficulty maintaining the home.
• The home became significantly less suitable as a main home for you and your family for a specific reason.

See IRS Publication 523 for more information.

[Opus 17]

---

@k2kennedy wrote:

Thank you! I can't find how much time is allowed between the hardship occurring and my closing date? Can I sell before my husbands actual job move date?

---

"Also are there rules around timing of the hardship and sale date?"

Not exactly, but the sale must be because of the change of circumstances.  If audited, you don't want to be in a position where the auditor could conclude that you moved for some other reason and are using the changed circumstances as a pretext. 

"This home was our main residence during the pandemic and continues to be during summers. All in all we will have lived in the home 18 months in the past five years. "

The hardship rule is based on how long you used the home as your main home, not how long you used it as a residence in general.   You aren't entirely, clear, but it sounds like the time you used the home as your main home was less than 18 months.

Overall, based just on what you have written here, this sounds like you had a main home somewhere else, and your beach home was your second home most of the time, although it may have briefly been your main home during the pandemic.  And you are now selling it out of convenience rather than necessity.   I don't have all the facts, of course.  Most taxpayers aren't audited, but if you were, you would need to prove that this was your main home for a period of time and that you sold it out of necessity. 

[k2kennedy]

When we purchased the beach house we intended it to be a vacation home but when the pandemic shutdowns occurred it became more attractive to live there than at our other home in Portland. In Sept 2021 schools opened here and I returned to our Portland home with our high school daughter. My husband has continued to go back and forth because he prefers the beach, works from home and it is a short drive. We were planning to live at the beach another six months before selling so we can claim the 2 of 5 year rule but thought it is possible we could qualify as a "hardship" for one of the reasons I mentioned. But you are correct in assuming that it is a bit of a pretext, although I am not sure why that matters if we legally qualify? Another option is just my husband claim the 2 of 5 rule for $250K exclusion and leave me out of it since I am unable to live their full time home due to my daughter's schooling and work. 

[Opus 17]

@k2kennedy 

The risk I see in your case is not with the definition of "hardship" but with the definition of principle residence.  Based on your story, I think it is reasonable to consider the beach house your main home from the shutdown until Sept 2022.  After that, it might still be your spouse's main home but I don't think it is your main home any more, if you spend more of your time in the city because of schooling, and go the beach on weekends.  (Especially because, you are not renting a temporary place in the city for school, you are returning to your previous main home.)

I'm going to look at this from a skeptical point of view, so you can the see kind of arguments that might be made against you, if you were unlucky enough to be audited.

Scenario one.  Your spouse moves back to the city, you list the property immediately and you sell it.  Your reason is the pay cut.  Being married imparts ownership but it does not impart residency.  I will assume you made the beach house your main home on July 1, 2021.  You have 13 months residency as your main home and your spouse will have 19 months if he lives there until the sale.  Your half of the gain is $150,000 and you can use a 54% exclusion, so $135K is excludable (54%x $250,000) and $15K is taxable.  Your spouse can use a 79% exclusion, so their entire $150,000 gain is excludable.  This seems reasonable to me. 

Scenario two.  Your spouse continues to live in the property to meet the full two year rule.  His exclusion is $250,000 but you don't meet the 2 year rule at all, so $50,000 of the gain is taxable on a joint return, unless you claim a hardship (because being married imparts ownership but it does not impart residency).  How could you claim a hardship due to pay reduction if your spouse was able to live in the home for a further 6 months before listing it?  You can't really claim a hardship for job change because the sale is not really because of the job change, if the sale is happening a year before the job change.

What about your home in the city?  Will that not also have a capital gain?  If you use the exclusion on the beach house, you can't use the exclusion on the city house for 2 years, unless you claim a hardship again.  And if you have a hardship that forces you to sell two main homes, then were they really both main homes?

Potentially, if you lived apart for a few more months, you could sell the beach house and exclude half the gain using your spouse's $250,000 exclusion, and then in 2024 sell the city home and exclude half the gain, using your exclusion.

You need to think about your city home, and then you may want to see a local professional tax planner.

The IRS says this:

An individual has only one main home at a time. If you own and live in just one home, then that property is your main home. If you own or live in more than one home, then you must apply a "facts and circumstances" test to determine which property is your main home. While the most important factor is where you spend the most time, other factors are relevant as well. They are listed below. The more of these factors that are true of a home, the more likely that it is your main home.

• The address listed on your:

1. U.S. Postal Service address,

2. Voter Registration Card,

3. Federal and state tax returns, and

4. Driver's license or car registration.

• The home is near:

1. Where you work,

2. Where you bank,

3. The residence of one or more family members, and

4. Recreational clubs or religious organizations of which you are a member.

https://www.irs.gov/pub/irs-pdf/p523.pdf

[k2kennedy]

Thank you and this is very helpful! It sounds like it may be best to focus on ensuring my husband has 24 months of documentation showing the beach house as his primary home. However, the IRS says the 24 months does not need to be consecutive, so is it possible to count the beach as my primary residence for three months during the summers and then switch back to my Portland house for the school year? That would allow me to add the summers of 2022 and 2023 to my residency and bring me quite close to the 24 month marker. In that case it may be worth delaying our sale by a few months for me to qualify for 2 of 5 rule.

Also we aren't planning to sell our house in Portland until at least 2026. Our children will be in college and want to have the option of living in Portland during the summers. We are hoping they will be ready to let go after a couple years of doing that.