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Article By: Jeff Skolnick, CPA, M.S. Taxation

One of the most common areas that I deal with each year is taxation upon the sale of a principal residence. I am going to outline some of the basics.

How much gain can I exclude from my income when I sell my house?

For married couples filing jointly that have owned and occupied the home as a principal residence for 2 of the last 5 years ending with the sale date, they can exclude the first $500,000 of gain. All others can exclude $250,000 assuming they meet the 2 out of 5 year rule. In addition, you must not have claimed an exclusion on any home in the last 2 years.

For purposes of the $500,000 exclusion, the ownership test is met if either spouse owns the home for 2 years. If only one spouse meets either the 2 year use test or has used the exclusion within the last 2 years then only the qualifying spouse is eligible for the exclusion and it is limited to $250,000.

I want to explain another situation that can occur with married couples. Let’s say each spouse owns a home entering the marriage and has satisfied the ownership and use requirements and also has not used the exclusion in the last two years. If each sells their own home and the couple purchases a new home each would be entitled to exclude $250,000 of gain on the sale of their former residence. Neither would be allowed a $500,000 gain as the spouse did not fulfill the use requirement (neither spouse used the other spouse’s former residence as a principal residence for 2 of the last 5 years).

Additionally, let’s say each spouse has owned their own home for the last 5 years and while they lived separately for the first 3 years of the 5 year look back and lived together for the last 2 years. Let’s also say that home they have lived together in for the last two years sold for a $350,000 gain, the other for a $200,000 gain and the couple bought a new house. In this instance they have a choice to exclude $250,000 of gain on one home and $200,000 on the second home or to exclude $350,000 on the home they lived in together. The reason they must make a choice is if they exclude $350,000 of gain as a married couple they cannot also exclude the $200,000 as each would have excluded a gain within the last 2 years. Obviously in this example it would make more sense to exclude $250,000 and $200,000 and pay tax on the $100,000 portion of the gain that exceeds the $250,000 limitation.

Another rule to keep in mind with spouses is upon the death of one spouse the remaining spouse can still exclude up to $500,000 of gain if the home is sold within two years of the death and the remaining spouse has not married.

One more thing to keep in mind for married couples (I know there a few but I want you to be well informed) is if one spouse dies the remaining spouse receives a step up in basis on their portion of the home. Let’s take an example where a couple purchased a home for $100,000 and it is worth $700,000 when the first spouse dies. The remaining spouse gets a basis of $350,000 on the first spouse’s portion (50% of the fair market value of $700,000) and $50,000 of their own basis (50% of the $100,000 basis). If the home is sold for $700,000 there would be a gain of $300,000 ($700,000 – $350,000 – $50,000). The surviving spouse could exclude all $300,000 if sold within 2 years of the first spouse’s death or $250,000 if the sale occurs later than 2 years after the first spouse’s death.

How do I calculate the gain or loss on the sale of my residence?

The gain or loss is calculated by starting with the gross sales price of the home, less any expenses of the sale (i.e. realtor commissions, attorney’s fees, realty transfer fees) less the basis of the house itself. 

How do I calculate the basis of my home?

The basis of your home is generally the original cost plus any improvements you’ve made to the home. Each year clients call and want to deduct things such as updating a kitchen or bathroom and are disappointed when I tell them they can’t deduct these items. Upon the sale of the home is where these items help. In other words, let’s say you purchased a home for $350,000. Let’s further assume that you redid the kitchen ($30,000), 2 bathrooms ($20,000) and you also put $25,000 into landscaping and a new driveway. In this example the cost basis would be $425,000 ($350,000 + $30,000 + $20,000 + $25,000). 

Assume a sales price of $700,000. Let’s also assume a realtor commission of 5% ($35,000) and additional expenses from the closing statement of $5,000. Sales price of $700,000 less $40,000 of expenses nets to $660,000. $660,000 less our previously calculated basis of $425,000 yields a gain of $235,000 and therefore no taxable income assuming the rules of using the property as a principal residence and prior use of this exclusion have both been met. Again keep in mind that a married couple filing jointly can exclude up to $500,000 of gain assuming both meet the tests outlined above

Other things to be aware of:

Even if you have had taken the exclusion within the last two years, you may be eligible for a reduced exclusion if your sale is the result of a change in employment, for health reasons or unforeseen circumstances. Additionally, there are special rules if you’ve used your residence for business purposes in the past.

Lastly, any loss you incur upon the sale of your residence is not deductible.

Conclusion

This article explains very quickly the basic principal residence sale rules, as always, I advise you to meet with a tax professional to help with these rules if you have any questions.

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LATE S ELECTIONS

Under certain circumstances a taxpayer may want to change their sole proprietorship, partnership or LLC into an S corporation. This may be done in order to minimize self-employment taxes or to take advantage of the new 20% deduction allowed for Qualified Business Income.

Generally S corporation elections must be filed (A) at any time during the preceding taxable year (in other words any time in 2018 if you are electing to be an S corporation beginning in 2019), or (B) at any time during the taxable year and on or before the 15th day of the 3rd month of the taxable year (March 15, 2019 for calendar year entities).  The election is made by filing Form 2553.

What if I apply after the 15^th day of the third month, is there any relief for late elections?

The good news is yes there is relief available if you’ve filed your S corporation election late and meet certain criteria.

Rev Proc 2013-30 outlines the criteria to be met and procedures to follow in case of a late S election.

The general rules of Rev Proc 2013-30 are as follows: (My comments on the rules in parentheses)

(1) The Requesting Entity intended to be classified as an S corporation as of the Effective Date of the election; (the company wants to become an S corporation)

(2) The Requesting Entity requests relief under this revenue procedure within 3 years and 75 days after the Effective Date (except in the case of certain corporations meeting additional criteria under this revenue procedure); (For a calendar year entity that wanted to be an S corporation beginning in 2019 this extended deadline would be March 15, 2022).

(3) The failure to qualify as an S corporation was solely because the Election Under Subchapter S was not timely filed by the Due Date of the Election Under Subchapter S; and

(4) In the case of a request for relief for a late S corporation election, the Requesting Entity has reasonable cause for its failure to make the timely Election Under Subchapter S and has acted diligently to correct the mistake upon its discovery.

If an entity meets all of the above criteria and follows the procedures outlined in the Revenue Procedure, then the S corporation election may be deemed as valid even though it is filed late.

Exception to the 3 Years and 75 Days Rule

Certain entities can qualify for the exception to the 3 years and 75 day rule when:

• The entity is a corporation (i.e., not a sole proprietorship, partnership or LLC seeking an entity classification election);
• The entity failed to qualify as an S corporation solely because the election was not timely field;
• The corporation and all its shareholders reported their income consistent with S corporation status for the year the S election should have been made and for every subsequent taxable year (if any);
• At least 6 months has elapsed since the date on which the corporation filed its tax return for the first year the corporation intended to be an S corporation;
• Neither the corporation nor any of its shareholders was notified by the IRS of any problems regarding the S corporation status within 6 months of the date on which the Form 1120S for the first year was timely filed; and
• The completed Election form includes the statements as described in the revenue procedure.  

Although this exception exists, it is unlikely many situations will qualify since the current system is set up to notify the corporation of the problem with its filing requirement when the return rejects in processing. It could apply to a case where it did not go through normal processing.

Conclusion

This article discusses procedures to allow entities to file S corporation election forms after the due date of day 15 of the 3^rd month after the effective date. Please keep in mind it is much easier to file the forms on time. This relief is to correct a situation in which that did not happen. The rules are very specific as are the procedures to be followed. I strongly suggest that if you are trying to take advantage of these provisions, then you should contact a tax professional familiar with these procedures.

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