Involuntary Conversion of a Principal Residence and What You Should Know to Avoid Paying Taxes

By Iryna Whitnah August 20, 2019

My friends and clients often ask questions regarding how much taxes would they owe to IRS if they sold a house or received payments from an insurance company for a casualty loss on the property. The mentioned transactions are called involuntary conversion. I wrote this article to help you better understand tax consequences of the involuntary conversion on your principal residence; and what you should know to avoid or defer paying a large amount of taxes on all or part of a gain realized on the involuntary conversion of your principal residence.

There are two provisions that homeowners should be aware of, sections 121 and 1033. Under Section 121, you may exclude a certain amount of gain on the sale or exchange of a principal residence if you meet the ownership and use test. Under Section 1033, you can defer any gain realized by replacing your principal residence with a different home within a specific period of time.

In general, taxpayers must include all realized gain in gross income. One commonly used exception allows you to exclude a gain of up to $250,000 ($500,000 if married filing jointly) from your gross income on the sale of your principal residence. Any remaining gain would be a long-term capital gain. To use this exclusion, you must have owned the home and used it as a principal residence for two years or more within the period of time of five years before the sale. The period of ownership and use do not need to be concurrent. Even if you don't meet the criteria described above, there are a couple of exemptions when you still may qualify for a reduced maximum exclusion due to certain unforeseen circumstances. The life events that can be outlined here include a sale by reason of a change in employment or health, or due to any other family or life situations. In this case, the maximum exclusion amount would be prorated and based on the actual numbers of days of ownership and usage of the home.

For married couples, the exclusion applies on a joint return and is up to $500,000. The exclusion applies if both spouses have used the house as a principal residence, either one has owned the home for at least two of the previous five years before its sale, or neither spouse has used the exclusion for a home sold within two years of the date of the sale of the current home.

Some rules apply to co-owners of the principal residence property. For example, if two unmarried individuals own a home jointly and each individual uses it as a principal residence, each owner may exclude up to $250,000 of realized gain, as long as each owner meets all other requirements.

What if you have two or more houses? Then determining which one is your principal residence depends on all the facts and circumstances. The home where you spend the most time is generally your principal residence.  Other factors to consider include your place of employment, home where your immediate family members live, address shown on your tax return and government documents, and your mailing address for bills. Location of your bank, location of your religious organization, and recreation club which you affiliated with can also be considered. 

During your temporary absence from home for business trips or vacations, the law considers such time as a period of use of the home as a principal residence as well. You even may rent the house to a tenant during your short temporary absence without reducing the time that the law would consider that you have occupied the home. So, let's say a couple of months of vacation or seasonal absences considered as a temporary absence will not cause any tax consequences. Be aware, though, that being away from home for longer than three months may run a risk of IRS not treating it as a short, temporary absence. And, a one-year absence to work elsewhere is definitely not a short, temporary absence.

Let's talk about casualty loss and gain and what you need to know in case your house gets destroyed because of fire, storm, shipwreck, or other unfortunate circumstances. A casualty gain on your principal residence may qualify for the Section 121 exclusion if the casualty significantly destroys the residence. To determine whether the significant destruction occurred, you need to compare the fair market value (FMV) of the object and the cost to repair. In case if the cost to repair a damaged home greatly exceeds its FMV before the casualty, then the house may have endured significant destruction. In this case, you may elect to apply the exclusion to the involuntary conversion within two years period to the subsequent sale of the vacant land, on which the destroyed house was set.   

There is also an option to elect out of the Section 121 exclusion. Electing out of the exclusion might be desirable when the gain is small, and you plan to buy or construct a new house that cost more than the amount realized on the involuntary conversion. In this case, you can defer all of the gains and use the exclusion on the later sale. The election out of the exclusion would be especially desirable if the property value expected to increase substantially in the next years, and you are planning to sell the house shortly thereafter. Remember that you are allowed to use the benefits of the exclusion only once every two years.

There are two types of an involuntary conversion, direct and indirect. Direct involuntary conversion of a principal residence occurs when a taxpayer’s property is destroyed or condemned, and the taxpayer received a replacement property directly rather than monetary compensation. In this case, you do not recognize a gain. Also, you may elect out of the deferral of the gain, and the basis of the property received would be the same as the property involuntarily converted.  Indirect involuntary conversion is more common than direct. In this case, the taxpayer receives monetary compensation rather than directly receiving a similar property. As such, the taxpayer recognizes any gain realized on involuntary conversion unless he or she purchases similar property within the time allowed and elects not to recognize the gain. The time allowed to purchase a similar property is generally two years from the end of the tax year in which gain is realized.     

I hope this article helps to understand the basics of an involuntary conversion, and after reading this article, you will understand the tax consequences and be able to plan your financial future wisely and properly. However, there are a lot of nuances that may exist when you are facing the involuntary conversion. In case you might have questions or concerns about the involuntary conversion, our professional team in Whitnah CPA is here for you to help and to advise.