 Personal Finance PowerPoint Presentation, Principal Residence Exclusion. Get ready to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Principal Residence Exclusion, which you can find online. Take a look at the references, resources, continue your research from there. This is by Ray Hartley Beck, published January 5th, 2022, qualifying for the Principal Residence Exclusion. So we're talking about a home ownership situation typically here and the selling of the home, which often raises concerns, because you're gonna get money for the sale of the home and you might have to include that in income. If it was having to be included in income for an income tax purposes as we have in the United States, then it could have tax consequences. Are there any benefits? There are, there could be an exclusion for if it was a principal residence. And so that's what we're gonna get into here. Also just keep in mind that when you make the sale of the home, the general calculation of the income that might be taxable to start off with, would generally be not the amount that you're going to be receiving, but the amount that you're gonna be receiving minus the adjusted basis, which includes like the cost and improvements, for example. So oftentimes people think, well, I'm gonna sell it for the 700,000. So I'm gonna have to think about that sales price as the amount that could potentially be taxable and then think about the exclusion and whatnot, but really you got the basis. If you bought it for the 300,000 and you have an adjusted basis of 300,000, then your starting point is the difference between the two. We're not taking into consideration the loans here, the financing, we're talking about how much you're selling it for versus the adjusted basis, kind of like the adjusted cost amount. So then that could still be significant, of course, because you might have owned the home for a long timeframe, which means it has a long time to appreciate. So therefore that could still be significant. And then we have the exclusion that could come into play if it would qualify as a principal residence. That's what we're getting into now. So to qualify for the principal residence exclusion, you must pass the ownership and use tests. In order to pass the ownership test, you must have owned the property you are selling for at least 24 months out of the five years leading up to the date of sale. So they want you to have owned it for this timeframe, a significant amount of time so that this isn't like a short-term finance kind of thing. This is supposed to be for people who are selling their principal residence. So which the IRS defines as the closing date, if you are part of a married couple, only one spouse has to be listed as the owner of the property for both to pass the ownership test. So you can imagine kind of complex situations when you're going from single to married to divorced and so on and so forth. So you could have to dive into that in a bit more detail in some cases. So to pass the use test, so then we have the use test, you must have used the home as your primary residence. So now we've got this term primary residence, basically you're living there, you're using that as your primary residence for at least 730 days or 24 months in the five years immediately proceeding the closing date of your home's sale. So this could be a significant factor for, like if you own one home and you live in it, it's pretty straightforward, right? Of course I lived in it for that time period as my primary residence, it's my home. But if you have multiple properties in retirement and now you're trying to liquidate some of those properties, possibly selling them, then you might think you might start to strategize and say, okay, well maybe I'll move into one particular property and have it as my principal residence for the required timeframe and so on and so forth. And things can get a little bit more complex in that kind of scenario and you can come up with some more complex strategies that may be beneficial under certain circumstances. So if you are a half, if you are half of a married couple, both spouses must have individually used the property for 24 out of the last 60 months in order to qualify for the full principal residence exclusion. So again, it can get a little bit more complicated in unusual kind of circumstances. Married's going from single to married, divorced and so on and so forth, so you could dive into that in a little bit more depth in certain situations. So qualifying for a partial exclusion, if you don't fully pass the ownership and use tests, you have a valid excuse for why you couldn't stay the two years. You can qualify for a partial exclusion with the percentage of the exclusion directly proportional to the percentage of time we're in your home. So if you can't qualify for the whole exclusion, you might be able to qualify for a partial exclusion. Now, depending on how much gain you have in the home, the partial exclusion might be fine. You might say, well, I need the whole exclusion because I want the maximum exclusion, but if you're gaining in the home is covered by the partial exclusion, then if that wipes out the gain, then that could be sufficient to move forward. So it's not like you're gonna get an exclusion, a tax benefit beyond what the income would have been recorded without the gain, in other words. So you're trying to say, okay, here's my sales price, minus the adjusted basis, there's the gain that might have had to be included in income had there not been an exclusion. And then you can look at the exclusion, which is usually quite high and wipes out the gain for many people, but it's not like you're gonna get a benefit beyond the amount that you were gonna include in income. It's just gonna wipe out the capacity that you would have to record it in income. So if a partial exclusion is enough to take care of that, then that might be a way to go. So valid excuses include moves related to health or to work or unforeseen circumstances according to the IRS. If, for example, your excuse is approved and you were in your home for one out of the past five years, then you have a 50% of your use requirement and can qualify for 50% of the exclusion on gains, 125,000 for single filers and 250,000 for married filing jointly. So you can see that's still a pretty hefty exclusion because again, you're not excluding the whole sales price, you're excluding the gain. So that might be enough in those circumstances. So exceptions, prior to 1997, individuals over the age of 55 did not have to pay capital gains tax on their homes and other property sales. In 2022, these adults have no such privileges but there are other exceptions to the two out of five year ownership and use tests. Official extended duty. So if you or both the individual selling a home in the case of a married couple is on official extended duty in the foreign service, intelligence community or uniform services, they can elect to suspend the five year ownership and use test period for up to 10 years. So that you obviously there's often gonna be exceptions for say members of the military in certain circumstances. So it gotta take into consideration that if that is your circumstance to meet the qualification of quote, official extended duty in quote, an individual must be at a duty station that is at least 50 miles from their main home or residing under government orders and government housing for at least 90 days. Disability, you may qualify for the full principal residence exclusion if you became physically or mentally unable to care for yourself, you can count time spent in a care facility licensed to care for people with your condition toward two out of the past five years use requirement. Death or divorce, in the event of death or divorce, you may be able to meet certain exceptions to the ownership and use test. So obviously that again, these get kind of confusing in situations divorce, the marriage divorce death situation when you look at these tests, widowed spouses can count their time, their spouse lived in the home toward the requirement for two out of five year residence, divorced spouses may be able to count the time for which their spouse owned the home toward the ownership test, but will still have to meet the use test themselves. Other ways to reduce or avoid paying capital gains tax. So we're talking capital gains tax because typically this would be a capital gains kind of sale your home. So again, you're talking about the general sale of the home had there been no exception, which would be the sales price minus the adjusted basis or cost. And then thinking if there's an exclusion due to the principal residence. So if you are unable to meet the requirements for the principal residence exclusion and you don't qualify for any of the main exceptions, you may still be able to avoid paying capital gains tax when selling your property. You've got the 1031 exchange. Now the 1031 exchange is not something we usually think about when it's gonna be your principal residence because we would like to sell it as your principal residence and get the exclusion. The 1031 exchange is usually with investment property can be a little bit more complex, but possibly an opportunity dependent on your circumstances. The 1031 exchange is a like for like exchange that allows individuals to defer paying capital gains tax. Notice it's more of a deferral kind of system because you're gonna make the exchange and then you're gonna have the basis impacted having a lower basis or cost in the new piece of property, which means that you're gonna end up paying the taxes when you sell the second piece of property that would be the general idea as opposed to an exclusion, which basically wipes out the ability the need to pay the taxes at that point in time. So defer the capital gains tax on their property, sale by immediately investing the proceeds in a substantially similar property. This exchange is only available if you are selling an investment property and it is a complex process. Consult with a tax professional or a 1031 exchange company to make sure you qualify and complete the steps correctly. Tax loss harvesting. So if you have an investment with an unrealized loss you are considering selling, you may be able to take advantage of tax loss harvesting to offset the capital gains from the sale of your home. Keep in mind that selling an investment at a loss just to offset capital gains taxes may not be the best financial decision because the investment you are selling at a loss may raise in value more than the taxes you will be saving. So in other words, if you have a gain capital gains you might say, well I'll sell some other property at a loss which will net out against the gain which means I won't be paying taxes but that would assume that you had other capital gain type property that you could sell at a loss and that you would want to sell at a loss and typically you don't have a situation where you're holding on to something that you would just simply want to sell. You might have a circumstance where that would be the case where you have something that's a loss and you're saying this is a good time to drop it at this point in time to net out the loss versus the gain for tax purposes. So calculate your basis correctly. So you pay capital gains tax only on your profit on the home sale which is the sales price minus your cost basis in the property. So remember if you're selling the home for 500,000 that doesn't mean that that's gonna be the amount that would be included in tax had there been no exclusion because you have to think about the cost or basis not the loan amount, not the financing, how much you paid for it, the basis and then any improvements in general and the difference then is what you're talking about as the possible capital gain which you might then be able to subject to an exclusion if you had the principal residence capacity exclusion. Make sure that you correctly calculate your cost basis by including the price you paid for the home, all transaction costs associated with buying and selling the home, real estate agent commission, title fees and so on and any meaningful improvements you made to the property with a useful life of more than one year. Now this can be a little bit complex when you're doing your own home because if it was investment property then you would be tracking all the stuff that you put into the property so that you can expense it or you can put it on the books as a depreciable item and depreciate it. When it's your personal home then when you do things like upgrades or you improvements to the home and so on you don't have as much incentive to track those because you don't have an immediate tax impact. However, if there are big improvements that you put into the home they could have an investment on the basis, the adjusted basis in the home so you do want to make sure to kind of hold on to those things so that when you sell the home you have an idea of what those improvements are. The bottom line, the principal residence exclusion is one of the easiest ways to reduce or eliminate capital gains taxes when selling your home. So it's something that if you're thinking about selling the home clearly you wanna think about whether you make sure you qualify for the capital gains tax if you're gonna have a gain, I mean sorry, the exclusion for the principal residence if you have the capacity to do so because it can of course be huge. Be sure to live in your home for 24 out of 60 months prior to your closing date to qualify for the exclusion. As always, when working with complex IRS rules regulations, exclusions and exemptions consider consulting with a tax planning professional to see what is best for your individual situation. So if you're selling your home clearly then that would be a big financial situation and if you're looking into this exclusion you'd probably wanna just double check and make sure that you've got all the boxes checked off in the event that you're selling it for a substantial gain so that you don't get hit with the tax bill. You can avoid as much of the taxes on that as possible because notice the sale of the home. One of the reasons they have this kind of exclusion is because the sale of a home means that you had income, you really incurred the income over a long period of time. If you had the home for 30 years then it went up in value not in one year, it went up in value in 30 years. So if you get hit with the income from it in one year if it wasn't capital gains, if it was ordinary income and there were no exclusion then you would be hit with a progressive tax system and you'd get this giant tax bill because you got the income all in one year instead of out over the multiple years. So that's some of the reasons why you got different rates for like capital gains rates and that's some of the justification for the idea that we should have some kind of exclusion. It also allows people possibly to move more easily especially at a point in retirement when they might need to sell their home and change things up at that point in time. So take a look, talk to the tax, tax professional.