Definng a ‘Principal Residence’ is Complex

By Sabrina Biehl Published Jul 11, 2014 12:28 pm Updated Feb 3, 2015 10:48 am

We call it our “principal residence” but the Internal Revenue calls it your “main home”. Either way, there are major tax benefits for American homeowners. You can deduct your mortgage interest and real estate tax payments while you own your house, and when you sell it, you may be eligible for significant exclusions from capital gains tax.

This year may be the last time that all of those tax benefits will be available; Congress wants to rewrite the tax laws and there are many proposals that will reduce — or even — eliminate those benefits. It is clear, however, that at least until the November elections, no Congressional action will take place.

It is interesting to learn that there is no statutory definition for principal residence in the Tax Code. If you ask an IRS agent — or your tax attorney — for a definition, she will advise you that “whether or not property is used by the taxpayer as his principal residence… depends on all the facts and circumstances in each case, including the good faith of the taxpayer.”

There have been very few court cases in which this concept has been defined, and in each opinion, the courts give the same answer: we will investigate the facts of each case, and make our decision based on those specific facts, on a case-by-case basis.

What facts are relevant? The Courts and the IRS look to where you vote, where you pay your local and state income taxes, where your driver’s license is issued, and even where your utilities are being used.

In its regulations, the IRS states that “the mere fact that property is, or has been, rented is not determinative that such property is not used by the taxpayer as his principal residence.”

Current tax law also makes it very clear that a taxpayer is not required to actually occupy the old residence on the date of sale. In order to qualify for the up-to $250,000 exclusion of gain (or up to $500,000 if you file a joint tax return) you have to have owned and used the house as your main home for two out of the five years before sale. Neither the IRS nor the courts have the authority to extend these statutory time periods.

The operative words are “owned and used”. If you are married, so long as either spouse meets the ownership test and both meet the use test, the exclusion of gain applies. Marital status is determined on the date the house is sold. In the event of a divorce where one spouse is given ownership pursuant to a divorce decree or separation agreement, the use requirement will include any time that the former spouse actually owned the property before it is transferred to the other spouse.

If you have two houses, and use each as a residence for successive periods of time (such as Florida in the Winter and Washington during the rest of the year), the property you use a majority of the time during the year will usually be considered the principal residence.

And it is to be noted that a cooperative housing apartment, a house trailer or a boat are also considered a “principal residence”, so long as there is a kitchen, sleeping quarters and bathroom facilities.

A surviving spouse can exclude the full $500,000 of gain if immediately before the death, he/she meets the ownership and use tests. However, this can only be done within two years after the death. Many widows have complained that this is unfair, since they may want to stay in the house for a longer period of time. But even though they can only exclude up to $250,000 of the profit at the end of the two year period, they have the right to step -up the tax basis. In simple terms, half of the value of the property on the date of the spouses’ death is added to the tax basis of the surviving spouse. The result: less profit, less tax to pay, and more money in the bank.

What if you are facing a significant profit (more than $500,000) and would like to have the house considered as “investment” rather than principal residence. In that case, you could swap — exchange — the house for another investment property and defer all taxes. This is known as a 1031 or Starker exchange.

Thus, the question becomes: how important is the concept of “principal residence” . The burden of proof is yours to demonstrate that this is — or is not — your principal residence.

How do you prove this?

what address is on your driver’s license and voting registration?
what address is on your utility bills?
what address is on your income tax returns?

All of these factors will play a role in determining the facts and circumstances of your particular case.

There is an old adage that your home is your castle. Whether it will also be your principal residence will depend on how carefully you have preserved and documented all of the relevant facts.