"Use Test" For Capital Gains

[AlmstRtrd]

My wife and I are getting ready to sell a property with a big capital gain (bought ages ago and it represents a huge part of our NW). We are hoping to be able to not pay gains on $500,000 profit. And, yes, I realize this is a first-world problem, but it's hopefully our last big step before being truly FI. My question is about the "use test" where we have to have lived in the property for at least two of the last five years. If push comes to shove is the burden of proof on us to show that we in fact lived there most of the last two years? Or would it be on the IRS to prove otherwise? We are back and forth between two properties (it's a long story) and quite honestly it's a close call as to which place we've spent more time in for 2016 and 2017. To be clear, before 2016 we definitely would fail the use test for any of the prior three years. The sale would be at the beginning of 2018.

Thanks in advance for any help!

[ixtap]

Which one of these homes is your legal residence?

[AlmstRtrd]

Well, I guess that's what I am really asking. The place we are trying to sell would be MY legal residence. The two places are in two different states. I vote and pay taxes in the state where the property in question is. My wife does not vote and pay taxes there but does spend a lot of time there (at least recently).

[secondcor521]

Here's how it works.

1.  You file your taxes.  Part of your taxes is your signature at the bottom saying that you believe you have filed everything accurately according to the rules.
2.  Based on a proprietary formula, the IRS selects a small percentage of tax returns for audit.  People with higher incomes or out-of-proportion deductions are more likely to be selected for audit.
3.  If you are not selected for audit, that's it.
4.  If you are selected for audit, you may or may not be asked about the house sale.
5.  If you are not asked about the house sale, that's it.
6.  If you are asked about the house sale, you'll probably be asked to prove that you qualify.  The IRS instructions may give guidance on what kinds of proof are acceptable, but in general contemporaneous written records are usually enough.  With larger items (like yours), I would probably be pretty careful in terms of the records I saved.
7.  If the IRS doesn't accept your records or evidence, they can disallow the exclusion and you'd be required to pay the taxes due and possibly interest and possibly penalties.
8.  If you disagree with the IRS, I believe there are tax courts where you can take your argument.  I wouldn't go there without a tax attorney, so that would get expensive.

[AlmstRtrd]

Thanks for that, secondcor521.

Any recommendation on records to save? I mean, we pay the utility bill, maintenance (it's a co-op building) and wifi bills every month. I have all of those.

We don't have a lot apart from that.

[secondcor521]

Thanks for that, secondcor521.

Any recommendation on records to save? I mean, we pay the utility bill, maintenance (it's a co-op building) and wifi bills every month. I have all of those.

We don't have a lot apart from that.

Whatever the IRS recommends.  I'd carefully read the instructions for the relevant exclusion.  For example:

https://www.irs.gov/publications/p523/ar02.html#en_US_2016_publink1000200611

Has several specific items that you could look at under "Main home".

[robartsd]

Well, I guess that's what I am really asking. The place we are trying to sell would be MY legal residence. The two places are in two different states. I vote and pay taxes in the state where the property in question is. My wife does not vote and pay taxes there but does spend a lot of time there (at least recently).

It certainly sounds like this was YOUR primary residence, but may not be your wife's primary residence; so worse case scenario is that you file separately and claim the excemption on your return, but pay capital gains on hers.

[AlmstRtrd]

Thanks robartsd & secondcor521.

Lots of good information here.... and maybe a few changes to make between now and the sale!

[secondcor521]

Well, I guess that's what I am really asking. The place we are trying to sell would be MY legal residence. The two places are in two different states. I vote and pay taxes in the state where the property in question is. My wife does not vote and pay taxes there but does spend a lot of time there (at least recently).

It certainly sounds like this was YOUR primary residence, but may not be your wife's primary residence; so worse case scenario is that you file separately and claim the excemption on your return, but pay capital gains on hers.

I strongly doubt that filing separately would be required for a partial exemption.

[robartsd]

I strongly doubt that filing separately would be required for a partial exemption.

I'm not sure it is; however, that is the worst possible scenario based on my reading of the IRS publication (no mention of taking 250k exemption on a joint return where only one spouse passes the residency test - but that doesn't mean it's not allowed) and the OP's statements. If I were in this situation I'd either adust plans so that both spouses can qualify for exemption or consult a tax professional.

The IRS publication does clearly state that the requirement for primary residence in 2 of the past 5 years does not have to be continuous - any combination of 730 days where the home was the primary residence in the 5 years preceeding the sale works.

[CareCPA]

To get into semantics, the publication doesn't even say it has to be the primary residence for both of you. It says if you are MFJ, you can take up to $500k exclusion. And the criteria is that it is " If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement." If never specifies if it is the plural "you."
There may be some court cases dealing with this, however. I don't have those resources at my disposal at the moment.

Don't take this as tax advice - mere devil's advocacy on this one.

[robartsd]

To get into semantics, the publication doesn't even say it has to be the primary residence for both of you. It says if you are MFJ, you can take up to $500k exclusion. And the criteria is that it is " If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement." If never specifies if it is the plural "you."
There may be some court cases dealing with this, however. I don't have those resources at my disposal at the moment.

Don't take this as tax advice - mere devil's advocacy on this one.

I thought I saw somewhere in the IRS publication that each spouse must pass the residence test. There's a couple of Nolo articles about that make some of the details more clear:
http://www.nolo.com/legal-encyclopedia/the-250000500000-home-sale-tax-exclusion.html
http://www.nolo.com/legal-encyclopedia/avoid-capital-gains-tax-selling-home-29901.html

[Drifterrider]

My wife and I are getting ready to sell a property with a big capital gain (bought ages ago and it represents a huge part of our NW). We are hoping to be able to not pay gains on $500,000 profit. And, yes, I realize this is a first-world problem, but it's hopefully our last big step before being truly FI. My question is about the "use test" where we have to have lived in the property for at least two of the last five years. If push comes to shove is the burden of proof on us to show that we in fact lived there most of the last two years? Or would it be on the IRS to prove otherwise? We are back and forth between two properties (it's a long story) and quite honestly it's a close call as to which place we've spent more time in for 2016 and 2017. To be clear, before 2016 we definitely would fail the use test for any of the prior three years. The sale would be at the beginning of 2018.

Thanks in advance for any help!

When is comes to justifying any deduction, the burden of proof is always on you. 

[taxedatty]

To get into semantics, the publication doesn't even say it has to be the primary residence for both of you. It says if you are MFJ, you can take up to $500k exclusion. And the criteria is that it is " If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement." If never specifies if it is the plural "you."
There may be some court cases dealing with this, however. I don't have those resources at my disposal at the moment.

Don't take this as tax advice - mere devil's advocacy on this one.

I thought I saw somewhere in the IRS publication that each spouse must pass the residence test. There's a couple of Nolo articles about that make some of the details more clear:
http://www.nolo.com/legal-encyclopedia/the-250000500000-home-sale-tax-exclusion.html
http://www.nolo.com/legal-encyclopedia/avoid-capital-gains-tax-selling-home-29901.html

Correct.  The cited publication states: "Married individuals may exclude up to $500,000 of gain if they file a joint return and neither spouse excluded gain on the sale of another home within a previous 2-year period. If one spouse meets the ownership requirement, both are considered to have met the requirement. See Eligibility Step 2—Ownership , earlier. However, each spouse must individually meet the residence requirement. See Eligibility Step 3—Residence , earlier."    However, this is just for both spouses to get the maximum exclusion.

The actual tax regulations have additional information and examples which may be helpful, https://www.law.cornell.edu/cfr/text/26/1.121-2, https://www.law.cornell.edu/cfr/text/26/1.121-3.  They detail the limitations and the rules for prorations of the exclusion.

Based on at least one example, it's clear that both spouses don't need to be eligible for one spouse to take the max individual exclusion, i.e. 250k, on a joint return.  Specifically: "Married Taxpayers H and W sell their residence and file a joint return for the year of the sale. W, but not H, satisfies the requirements of section 121. They are eligible to exclude up to $250,000 of the gain from the sale of the residence because that is the sum of each spouse's dollar limitation amount determined on a separate basis as if they had not been married ($0 for H, $250,000 for W)."

There seem to be other rules where proration of the exclusion would be allowed (see the 1.121-3 reg), although it's a ton of facts and circumstances to consider -- and potentially hard to substantiate.  For what you may save with an additional 250k exclusion, it's probably worth getting advice from an attorney deals regularly with individual tax.