Unlocking the Benefits: How the Capital Gains Exclusion Works

Recently I received a telephone call from a client looking to sell their home.  The home had been transferred to a trust years earlier and they wanted to know if they would qualify for the $250,000 (per resident owner) capital gains exclusion on the sale of their home.

Generally speaking, the Internal Revenue Code provides, with certain limitations and exceptions, that gross income does not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, the taxpayer has owned and used the property as the taxpayer’s principal residence for periods aggregating 2 years or more.  An individual taxpayer may exclude up to $250,000, and certain taxpayers who file a joint return may exclude up to $500,000 of gain from the sale or exchange of such property.

In fact, a couple may exclude up to $500,000 of gain on a joint tax return even if only one spouse satisfies the ownership requirements, however, both spouses must satisfy the use test.

In determining use, the IRS looks to:

1. Was this their primary residence?
2. Did they have beneficial enjoyment of the corpus of the trust?
3. Do they have the exclusive use, possession and occupancy of the residence?
4. Is the income subject to a power of disposition, exercisable by the creator of the trust without approval or consent by another party?

After doing a detailed assessment of the trust in relation to the prongs that the IRS requires for the exclusions, we were able to appeal to the IRS.  We amended the tax returns for this client and received a full refund of the tax on the capital gains that their accountant had them pay at the time of the sale.