Tax issues for nontraditional households

By Claudia L. Kelley, CPA, Ph.D., and C. Kevin Eller, Ph.D.

 PHOTO BY IN4MAL/ISTOCK
PHOTO BY IN4MAL/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Demographic and cultural changes make it increasingly likely that unmarried people will purchase and/or live in a home together.
  • The tax results of various transactions for homeowners can be affected by the form of ownership of the home, making it important for potential co-owners to carefully consider which form of home ownership is best for them.
  • Although mortgage interest may, in some cases, be deductible by someone who does not hold an ownership interest in the property, real estate taxes are usually only deductible by a property owner.
  • The interest exclusions for up to $1 million of acquisition indebtedness and up to $100,000 of home-equity indebtedness apply to unmarried co-owners on a per-taxpayer basis. Unmarried taxpayers also qualify separately for the $250,000 exclusion of gain from a sale of a principal residence.
  • The casualty loss rules and the involuntary conversion rules also apply separately to unmarried owners, allowing for additional opportunities to use tax planning to get the best results.

Cultural changes have radically transformed the mix of household types over the past several decades, with the number of nonfamily households increasing and married-couple families decreasing. Several trends have contributed to this change, including more working women, delayed marriage, high divorce rates, and greater acceptance of unmarried couples living together. The opportunity to share home costs and other economic factors also drive adults to live together. The aging population brings more elderly, single homeowners seeking companionship or financial assistance. As a result of these trends, more unrelated individuals are becoming joint homeowners. These individuals cannot file a joint income tax return, and questions arise as to who is able to deduct or otherwise take advantage of the tax provisions available to homeowners. For these individuals, the complexities of tax deductions, income, and credits are compounded.

This article explores the income tax issues that arise from owning or living in a home with a person other than a spouse. Although sharing of a personal residence is the focus of this article, much of the tax law discussed may apply to other types of jointly owned property. Tax planning suggestions and strategies for these ownership structures are also provided.

Terminology and types of ownership

Tenancy in common

Two or more unmarried individuals can own real estate as either tenants in common or joint owners. Tenants in common have separate but undivided interests in the whole property. There are no rights of survivorship, and each interest may be conveyed by deed or will without restriction. Tenants are allowed to sell their interest in the property without the consent of the co-owners.

In a tenancy in common, each co-tenant owns an equal share of the property, which means that each co-tenant has an equal right to possess or use the entire property and the rent or maintenance costs of the property are shared among the co-tenants according to their ownership interests. Each co-tenant shares in the value of the property as it appreciates. A co-tenant cannot sell or transfer the other co-tenants' interests in the property.

Joint tenancy

Joint tenancy is sometimes called "joint tenancy with right of survivorship." The main advantage of holding property as joint tenants is that it allows property to pass automatically to the survivor when the other owner dies. The property need not pass through a will and avoids probate.

A disadvantage of joint tenancy is shared control of the property, as each joint tenant must consent to any action for the property. A joint tenant loses all interest in the property at death. The deceased person's interest is automatically transferred to the other joint tenants. There may be tax consequences when one joint tenant dies and the other tenants become owners of the deceased person's share. Individuals who desire to create a joint tenancy should seek the advice of an attorney to make sure the proper phrasing appears on the deed.

Title vs. deed

Title is distinct from a deed. For real estate purposes, title refers to ownership of the property. A deed is a document that transfers ownership of real estate to another party. A quitclaim deed is used when the ownership of property is transferred without being sold. Unlike a warranty deed, a quitclaim deed does not provide the new owner with any guarantees that the seller owns the property or that the property is free of any liens.

Quitclaim deeds are typically used to transfer property between people who are familiar with one another and who have an established, trusted relationship. Quitclaim deeds may be used to add or remove owners on the title, which can change the tax consequences for the individuals sharing a residence. Tax practitioners should be aware of how their clients own and finance property because these factors may affect the tax consequences.

Common home-related deductions

Mortgage interest

Individuals apply for a joint mortgage for a variety of reasons, including increased buying power and improved eligibility for the loan. A joint mortgage is not the same as joint ownership. In a joint mortgage, all parties involved are agreeing to the loan, and each party is equally liable. A person who is not living in the home and is not an owner of the home may nonetheless be obligated on the mortgage. For example, a parent may be jointly liable on the mortgage with a child.

Sec. 163(h) allows a deduction for interest paid on acquisition indebtedness for the taxpayer's personal residence. Generally, to claim the interest deduction it is necessary to be liable on the note.1 However, Regs. Sec. 1.163-1(b) provides that interest the taxpayer paid on a mortgage upon real estate of which he or she is the legal or equitable owner, even though the taxpayer is not directly liable upon the note secured by that mortgage, may be deducted as interest on the debt. In several cases, a court permitted a taxpayer to deduct interest on the debt even though the taxpayer was not liable on the mortgage.

In Uslu, married taxpayers were entitled to the interest deduction even though they did not hold legal title to the home and were not liable on the mortgage.2 The taxpayers were able to establish equitable ownership of the property by making every mortgage payment since the time of purchase, paying all expenses for maintenance, taxes, and insurance, and being the sole occupants of the home. It was important to the court that the husband's brother, who purchased the property and obtained the mortgage loan, did not act in any way as owner of the property.

However, in other cases courts denied taxpayers who were not directly liable on the mortgage note the interest deduction for residences owned by another because they failed to prove they were the legal or equitable owners.3 In Jackson, the Tax Court denied a boyfriend who lived in a home owned and financed solely by his partner the mortgage interest deduction because he failed to prove equitable ownership of the property.4

An individual becomes the equitable owner of property when he or she assumes the benefits and burdens of ownership. Relevant factors include whether the taxpayer (1) has the right to possess the property and enjoy the use, rents, or profits from the property; (2) has the duty to maintain the property; (3) is responsible for insuring the property; (4) bears the risk of loss of the property; (5) has the obligation to pay taxes and assessments against the property; and (6) has the right to obtain the legal title to the property at any time by paying the balance of the purchase price.5 To show equitable ownership, taxpayers should continuously treat the property as if they were the owners and be able to demonstrate that they have exclusively held the benefits and burdens of ownership.

Individuals who are not personally liable on the mortgage because the debt is nonrecourse may nevertheless deduct the interest paid. Regs. Sec. 1.163-1(b) recognizes the economic substance of nonrecourse borrowing and permits the individual to deduct the interest payments. On a nonrecourse loan, the taxpayer must pay the interest to protect his or her interest in the property by avoiding foreclosure.6

The IRS and the courts have often addressed the mortgage interest deduction for taxpayers who are jointly liable but filing separate returns.7 Under normal circumstances, a deduction for a joint obligation is allowable to whichever of the responsible parties makes payment from his or her separate funds.8 If the taxpayers pay interest from a joint bank account, it is presumed that each account holder paid an equal amount absent evidence to the contrary.9 In the case of married couples, both of whom are joint makers on the mortgage note, the IRS ruled that the amount of interest and taxes actually paid by each is deductible on their separate returns.10 When various combinations of individuals are jointly and severally liable on the mortgage, the person who pays all or some portion of the interest is entitled to the deduction provided the interest is otherwise deductible.11 In summary, the interest deduction on a joint obligation is allowed to whichever of the liable parties makes the payment out of his or her own funds.

Points

Cash-method taxpayers may not deduct interest in advance of the period to which it relates.12 However, an individual taxpayer may deduct points (prepaid interest) in the year paid if the taxpayer uses the loan to buy or improve the taxpayer's principal residence and the home is security for the loan.13 Loan origination fees paid for loan processing services are not deductible interest and should be included in the basis of the acquired property.14 For the points to be deductible, a taxpayer must pay them from funds separate from the loan principal at the time of closing.

Taxpayers may choose to amortize the points paid over the loan term.15 If the individual's total itemized deductions are less than the standard deduction, it may be beneficial to amortize the points. Unmarried individuals are not subject to the rule that requires married taxpayers who file separately to both itemize.16 Co-owners of a principal residence who are jointly liable for the mortgage may each deduct any points paid to purchase or improve the home subject to the interest limitations discussed below.

Real estate and property tax

Generally, real estate taxes paid are deductible only by the person subject to the tax.17 However, many jurisdictions impose real property taxes on the property rather than the owner. In recognition of this, Regs. Sec. 1.164-3(b) defines real property taxes as taxes imposed on interests in real property. Where the tax is not a liability of any person, the person who holds the property at the time the tax becomes a lien on the property is considered liable for the tax.18 The courts have consistently ruled that taxes paid by a person that are assessed on property owned by another are not deductible by the payer.19 For example, in Tuer, the taxpayer was not entitled to deduct real estate taxes on behalf of her incompetent father because she was not the owner of the property.20

Real property taxes are deductible only by a person with an ownership interest in the property.21 When two or more persons own real property together, the deductibility of taxes paid depends on the form of concurrent ownership involved. Tenants by the entirety (tenants in common who are spouses) who file separate returns may each deduct the real estate taxes that they actually pay.22 In many localities, tenants in common are jointly and severally liable for property taxes. Joint and several liability means that either owner can be required to pay the full amount of the tax due. In this situation, each owner is entitled to deduct the amount of tax he or she actually paid.23

In jurisdictions where tenancy in common does not impose joint and several liability for property taxes, each owner is entitled to deduct only his or her share of the tax owed, regardless of how much that owner actually paid.24 For example, a taxpayer who paid the entire amount of property taxes on property held in common with his sister was not allowed to deduct the total amount because only one-half was assessed against him.25 In similar cases, taxpayers who paid a nonproportionate share of interest and taxes arising from property held in co-tenancy were allowed to deduct only their proportionate share.26

However, in some cases, tenants in common without joint and several liability have been allowed to deduct the full amount of tax paid, even though it went beyond their proportionate share, on the theory that the tax payment was necessary to avoid personal liability or preserve the owner's interest in the property. For example, the taxpayer in Powell was entitled to deduct all the taxes paid on property co-owned with five siblings as tenants in common. The property was subject to foreclosure; thus, the court found it was necessary for the taxpayer to protect the common property to preserve her individual interest in the property, and therefore she was entitled to deduct all the taxes paid.27 When it is necessary to preserve a tenant's interest in the undivided whole and one tenant pays the entire amount of taxes due, then that tenant should be entitled to the deduction for the amount paid.28

In summary, when a jurisdiction imposes a tax on a property rather than on a person, the legal owner of the property is generally entitled to the deduction. In the case of unmarried individuals sharing a home, it is important for the practitioner to determine who owns the property, the form of ownership, and who is liable under state law.

Preserving a deduction: Indirect gifts

There is no strict requirement that the person taking the deduction must have paid the tax. In certain circumstances, a taxpayer may be allowed to deduct taxes even though another person pays them. When another party pays taxes on behalf of the owner of the property, it may be treated as a loan, compensation, rental income, or a gift to the owner, in which case the beneficiary of the payment (the property owner) may then deduct the taxes.29 The regulations identify indirect gifts, such as payments to a third party on behalf of a donee, as a transfer to the donee.30

In the case of individuals sharing a home, absent an employee-employer relationship or evidence of a loan, the likely outcome is a gift. In Lang, the Tax Court allowed the taxpayer to deduct real estate taxes paid directly to the city government by her mother. Lang owned the home, and her mother was not legally obligated to pay the expenses. The payment was treated as a gift of the funds to Lang, and Lang was entitled to the deduction because she was the owner of the property.31

The indirect gift treatment preserves the tax deduction, although not for the payer. This may be beneficial to individuals who are living together and sharing home expenses but for whatever reason the owner does not or cannot pay the tax. Individuals seeking to benefit from the tax deduction can be added to the deed via a quitclaim deed. However, there may be some gift tax consequences (and other legal responsibilities) from changing owners. Taxpayers should seek the advice of their tax adviser before proceeding.

Individuals often take over the cost of maintaining a home for someone who is ill, away, or otherwise unable to manage his or her home's finances. As already discussed, a person paying taxes and interest on behalf of the owner of the property will not be able to take the deductions. The payments are in substance gifts (or some other form of advance of funds to or for the benefit of the owner of the property).32 The property owner will not recognize income from the gift but can deduct the interest and taxes. However, the payer may have gift tax reporting obligations depending upon the amounts involved (i.e., amounts in excess of the annual exclusion).33

If the payment to a third party on behalf of another person is not a gift, then the amount should be included in the income of the person on whose behalf it is paid. Unmarried individuals who share a home must be aware of the potential gift and income tax consequences of paying more than their share of the home expenses. This is especially important when an unrelated adult is living in the home and paying home expenses but is not an owner of the property.

Other common tax issues

Co-signers, guarantors, and endorsers

Case law has established that for interest to be deductible, the interest must be on the taxpayer's own indebtedness.34 A co-signer who pays the interest on the note is entitled to the deduction for the amount paid, as a co-signer of a note is jointly liable.35 Alternatively, a taxpayer's guaranty of a debt does not transform the debt into the taxpayer's obligation. A person who makes payments on a guaranty may deduct interest paid or accrued only after the default of the primary obligor. Default is the point at which the guarantor becomes primarily and directly liable for the debt and the interest.36 Generally, under state law, an endorser is considered primarily liable on a note, as is the maker. Thus, endorsers are joint obligors and may deduct interest they actually pay on the note.37

Qualified residence interest limits

In Chief Counsel Advice (CCA) 200911007, the IRS examined how the $1 million limitation on acquisition indebtedness under Sec. 163(h)(3)(B)(ii) applies to a partial owner of a residence. According to the Service, acquisition indebtedness is debt incurred in acquiring the taxpayer's qualified residence, not debt incurred to acquire the taxpayer's portion of a residence. When the mortgage exceeds the $1 million debt limit, the IRS concluded that the amount of qualified residence interest for each taxpayer is determined by multiplying the amount of interest paid by the taxpayer by a fraction, the numerator of which is $1 million and the denominator of which is the average mortgage debt outstanding during the year.

However, the Ninth Circuit concluded otherwise. In Voss, two unmarried individuals who were co-owners of real property each claimed mortgage interest on $1 million of mortgage borrowing and $100,000 of home-equity borrowing on their separate returns. The court allowed each individual to deduct the interest on the mortgage borrowing up to the statutory limit.38 According to the court, the debt limit provisions apply on a per-taxpayer basis to unmarried co-owners of a qualified residence rather than on a per-residence basis.

The IRS acquiesced to the Voss decision's per-taxpayer interpretation of mortgage interest deduction.39 The court's interpretation is a windfall to unmarried couples who are homeowners, allowing these co-owners to deduct interest on up to $2.2 million of debt, while married co-owners can only deduct interest on debt up to $1.1 million. Additionally, unmarried taxpayers who co-own a residence will not be restricted to the $500,000 acquisition debt limit and $50,000 home-equity debt limit for married individuals filing separate tax returns.40

Information reporting

Several individuals who co-own a house may each be liable on the mortgage. The bank may issue a Form 1098, Mortgage Interest Statement, under the name of one or all co-obligors. As discussed previously, taxpayers may claim a deduction for the interest actually paid from separate funds. Lenders generally issue a Form 1098 to the principal borrower, which is often the first name listed on the mortgage.41

Even though a co-owner did not receive a Form 1098, the individual is still entitled to deduct any interest paid during the year subject to other limitations discussed previously. Individuals claiming the deduction without receiving a Form 1098 should attach a copy of the form and a written explanation with the tax return. The co-owner receiving the Form 1098 should also attach a statement to his or her tax return explaining the amount of interest deducted.

Casualty losses

Many homeowners incur costs resulting from storms, fires, and natural disasters. Understanding the casualty tax rules is particularly difficult for unmarried joint owners. Under Sec. 165(c)(3), an individual may deduct a casualty or theft loss from nonbusiness property not compensated for by insurance. Each loss is subject to a $100 floor, and net losses for the year are deductible only to the extent the sum exceeds 10% of the taxpayer's adjusted gross income (AGI).42 The amount of the loss is the lesser of the property's decline in value as a result of the casualty or the property's adjusted basis.43 A casualty loss is deductible for the tax year in which the taxpayer sustains the loss, although special rules exist for taxpayers in federally declared disaster areas who may elect to take the loss in the previous year.44

Generally, only the owner of the property at the time of the loss may take the casualty loss deduction.45 Among other things, this ownership requirement prevents a parent from taking a deduction for a casualty that damages the child's property.46 Married individuals holding property as tenants by the entirety are each entitled to deduct one-half of the loss sustained to real property on their separate tax returns.47 This is true even if one spouse pays the entire amount of the casualty costs. However, whoever individually owns the personal property within the home may claim the entire loss to the personal property.48 To apply the casualty loss rules to unmarried individuals, it is necessary to determine who owns the property.

Casualty and theft losses on property owned by more than one person are allocated between the owners on the basis of their proportionate interests in the property.49 The $100 per-event floor applies separately to each individual owner who sustains a loss.

Example 1: A and B are joint owners of a house destroyed by a tornado. The basis of their home was $100,000. A and B each have a $50,000 loss. The deductible amount is reduced by any insurance reimbursement; the $100 floor and the 10%-of-AGI limitation are applied separately to A and B.50 If one co-owner pays the entire amount of the casualty costs, that person's deduction is still limited to his or her proportionate interest in the property.

Involuntary conversion

A homeowner may defer a realized gain on an involuntary conversion of a principal residence. To do so, the homeowner must use the proceeds from the conversion to purchase replacement property similar in service or use to the converted property. In this case, the replacement property should be another home used as the taxpayer's residence.51 Taxpayers who receive monetary compensation for the conversion of property have the option to elect to defer the gain. If a taxpayer makes the election, he or she recognizes the realized gain only to the extent that the amount realized from the conversion exceeds the cost of replacement property.52 The basis of the replacement property is its cost less any deferred gain.53 The taxpayer is permitted a two-year period (after the end of the tax year in which the taxpayer realizes a gain from the involuntary conversion) to acquire replacement property.54

Example 2: C's home (basis $80,000) is destroyed by a fire on May 20, 2016. C receives insurance proceeds in the amount of $200,000 on July 20, 2016, and purchases a replacement home for $170,000 on March 10, 2017. Unless C elects to use the Sec. 121 exclusion (discussed below), C must recognize $30,000 on the conversion and may elect to postpone the remaining gain of $90,000. C's basis in the new home is $80,000 ($170,000 - $90,000).

Joint homeowners may also elect to defer realized gain on the involuntary conversion of their home or partial interest in the home. The IRS has ruled that a taxpayer who owned a one-half interest in a piece of property can elect, as to his separate interest, to apply Sec. 1033 to the gain from the involuntary conversion.55 The IRS also ruled that a wife who failed to reinvest her one-half of the proceeds from the involuntary conversion for real property was required to recognize her share of the gain.56 Co-owners may each elect separately whether to defer realized gain from an involuntary conversion. These owners may purchase a separate residence, another jointly owned home, or some other partial interest in a home. The new property, however, must be used as a residence to satisfy the similar-in-use rule in Sec. 1033(a)(1).

Involuntary conversion and Sec. 121 exclusion

Sec. 121(d)(5) treats an involuntary conversion of a personal residence as a sale of the residence. Thus, if the home meets the gain exclusion requirements, some or all of the gain may go untaxed. The home must be completely destroyed for the Sec. 121 exclusion to apply.57 For purposes of Sec. 1033, the amount the taxpayer realized on the involuntary conversion is determined without regard to Sec. 121 and then reduced by the statutory exclusion amount under Sec. 121.58 The remaining gain may be postponed under the involuntary conversion provisions.

Example 3: On March 10, 2015, a hurricane destroys H's principal residence (basis $100,000). H, who is single, purchased the residence in 2000 and used the property as a residence until it was destroyed. On July 1, 2015, H received insurance proceeds of $400,000 for the house. On November 20, 2015, H purchased another home for $120,000. H's realized gain is $300,000. H may elect to exclude $250,000 of the realized gain. For Sec. 1033, the amount realized is $150,000 ($400,000 - $250,000). H can now elect to recognize only $30,000 of the gain under Sec. 1033 and defer the remaining gain. H's basis in the new home is $100,000 ($120,000 - $20,000).59

As noted previously, co-owners of a residence may each use the Sec. 121 exclusion as well as Sec. 1033 involuntary conversion gain deferral on the same forced sale. The flexibility that these rules provide to unmarried co-homeowners increases the opportunities for these individuals to decide separately how to benefit from these provisions. For example, co-owners in different tax brackets are not required to agree on the election to defer the conversion gain, which also provides an opportunity for those owners who desire a higher basis in the replacement property to recognize their share of gain regardless of what the other owners do. Additionally, one co-owner who reinvests in nonqualified replacement property will not preclude the other co-owner from using Sec. 1033.

Home services and costs paid by nonowners

Whenever unmarried adults share a residence, a question may arise whether services the nonowner performs in the home are in lieu of rent. If the nonowner resident is expected to perform the services as a condition of living in the home, then both the homeowner and the tenant recognize income (rent or compensation) equal to the value of the services or rent received.60 The homeowner reports the income on Schedule E, Supplemental Income and Loss, and may be entitled to deduct some home expenses in addition to those expenses allowed regardless of the rental activity.61 For example, if the homeowner rents out one room in the home, he or she can deduct an allocated portion of the home costs as rental expenses. If there is no intent to make a profit from the rent, the rental deductions are limited to rental income under the hobby loss rules in Sec. 183. Sec. 280A contains additional restrictions on deductions related to rental of a personal residence that are beyond the scope of this article.62

In many cases, individuals share a residence with a relative, romantic partner, or friend. In these situations, the service-for-rent exchange may be a gift, which the recipient can exclude from income.63 If it is not a gift, the IRS could view the individuals as being involved in an employee-employer relationship.64 The distinction between compensation and a gift is based upon the payer's intent.65 The transfer is a gift if the transferor makes it because of generosity, love, affection, respect, or similar motives.66 The burden of proof is on the gift recipient.67 If the exchange is a gift, there are no income tax consequences, but gift-tax filing obligations may apply if the amounts exceed the annual exclusion.68

Not all owners live in residence

For various reasons, many individuals are not able to purchase a residence. For example, they may not have any savings for the down payment despite having sufficient income. Possible solutions for the aspiring homeowner include borrowing the down payment (e.g., from a relative) or purchasing the home with a co-owner. For the interest on the borrowed funds to qualify as qualified residence interest, the debt instrument must state that the residence serves as security for the debt and the instrument must be properly recorded under state law.69 Otherwise, the interest on the debt will be nondeductible personal interest.

Co-owners who do not reside in the home will not be eligible for a mortgage interest deduction unless the home is treated as their second home or the interest is treated as investment interest.70 However, the nonresident owner will be entitled to deduct real estate taxes paid. Ideally, the co-owners should structure the arrangement so that each co-owner pays his or her share of principal and interest on the debt. However, as noted previously, if the resident of the home pays all the interest expense, the portion paid on the other co-owner's share may still be deductible if both parties are jointly liable on the mortgage. If the taxpayer living in the home is not also an owner (e.g., when a parent purchases a home for a child) but pays all the interest, the taxpayer may be entitled to the full deduction if he or she is the equitable owner of the home. The factors that demonstrate equitable ownership are discussed earlier.

In addition to helping a child purchase a home, parents may choose to co-own the home with a child as an investment. Co-ownership of property with a parent raises many issues, including future appreciation in the parent's estate and how to handle remodeling and refinancing decisions.71 The home should qualify as investment property to the nonresident (parent) owner because the nonresident-owner shares in the property's appreciation. Interest paid by the nonresident-owner qualifies as investment interest, which is deductible to the extent of the individual's investment income.72

The payment of other home expenses, such as insurance and maintenance, will not be deductible to the resident-owner (see Sec. 262). However, these expenses are deductible as production of income expenses of the investor-owner.73 Whenever one co-owner in a tenancy-in-common ownership pays more than his or her share of the expenses, the excess expenses paid are income, a loan, or a gift to the other owner, as discussed in a previous section.74

If the nonresident-owner is treated as renting the property to the resident, then the passive activity loss rules may apply. The nonresident-owner will not be able to exclude any gain on a sale of the property under Sec. 121, but the nonresident-owner can deduct any suspended passive activity losses in the year of sale. Any further discussion of the tax issues for the investor-owner is beyond the scope of this article. Because the resident and nonresident owners have different tax outcomes, it is important for these individuals to seek assistance from their tax advisers to properly structure the purchase of the property and the payment of home expenses.

Sale of residence

Sale of residence by joint owners

The Sec. 121 exclusion of gain on the sale of a residence is available to unmarried joint owners. To exclude gain, a taxpayer must both own and use the home as a principal residence for two out of the five years before the sale.75 The ownership and use tests do not need to be concurrent.76 The regulations provide that if taxpayers jointly own a principal residence but file separate returns, each owner may exclude up to $250,000 of gain attributable to their respective interest in the property if they otherwise meet the exclusion requirements (i.e., ownership and use tests).77

Example 4: Unmarried taxpayers A and B are joint owners of a house, each owning a 50% interest in the house. They sell the house after owning and using it as their principal residence for two full years. The gain from the sale is $256,000. A and B are each eligible to exclude $128,000 of gain because the amount of gain allocable to each of them from the sale does not exceed each taxpayer's $250,000 limit.78

To be eligible for the exclusion, the taxpayer must not have sold property for which he or she excluded gain during the two-year period ending on the date of sale.79 Interestingly, co-owners are able to take advantage of a larger total exclusion than married individuals, who are limited to $500,000 (or $250,000 filing separately). As long as each unmarried co-owner satisfies the Sec. 121 ownership and use tests, each may exclude up to $250,000 of his or her share of the gain from the sale. Thus, four co-owners could exclude up to $1 million of the gain from the sale of a single residence.80

Sale of partial interests

Unmarried homeowners may be more likely to relocate separately and as a result have to sell their share of the home. No gain or loss is recognized on property transfers between spouses;81 however, sales of property between unmarried individuals, including sales of partial interests in a residence, are taxable events. Fortunately, a taxpayer does not need to sell his or her entire interest in the residence to receive the Sec. 121 gain exclusion.82 The sale may be to an existing owner or another party. For purposes of the maximum exclusion limitation, sales of partial interests in the same residence are treated as one sale.83

Example 5: In 2012, A buys a house that he uses as his principal residence. In 2014, A's friend, B, moves into A's house, and, in 2015, A sells B a 50% interest in the house, realizing a gain of $136,000. A may exclude this gain. In 2016, A sells his remaining 50% to B, realizing a gain of $138,000. A may exclude $114,000 ($250,000 - $136,000 gain excluded previously) of the $138,000 gain from the sale of his remaining interest.84

Note that for purposes of the rule allowing only one sale in a two-year period, each sale of a partial interest is disregarded with respect to the other sales of partial interests in the same residence.85 To be eligible for the exclusion, the property must be the taxpayer's principal residence. Whether the property qualifies as the taxpayer's principal residence depends on the facts and circumstances.86 Unmarried co-owners may find that the property is the principal residence of one but not all of the owners. The partial interest rules provide flexibility for the owner of the principal residence interest to exclude his or her share of the gain even though the home may not qualify as the principal residence of the other joint owners.

Reduced exclusion

Sec. 121(c) provides for a reduced exclusion if a taxpayer does not meet the two-year use and ownership test due to a change in employment or health, or other unforeseen circumstances.87To take advantage of the reduced exclusion, the sale must be due to a change in employment or health, or other unforeseen circumstances of a qualified individual. A qualified individual includes not only the taxpayer and the taxpayer's spouse, but also a co-owner of the residence, as well any person whose principal place of abode is in the same household as the taxpayer. In the case of health-related sales, an individual related to any of the qualified individuals listed above generally is also a qualified individual.88 Thus, sales resulting from health, employment, or circumstance changes for any co-owner or resident of the home may qualify for the reduced exclusion. Because the regulations define a qualified individual so broadly, sales by nontraditional co-owner households have many opportunities to take advantage of the reduced exclusion.

Example 6: Unmarried individuals A and B purchase a residence on June 1, 2015. B's grandchild C also lives in the home. C's newly diagnosed health problem results in A and B selling the home (on April 1, 2016) to relocate for C's medical treatment. Any gain on this sale should qualify for the reduced exclusion.

Example 7: C and D live in Greensboro, N.C. They jointly purchased their residence on June 1, 2016, and have lived in the home since that date. During 2017, D's employer transferred him to a new job in Oakland, Calif. C and D sell their home for a gain of $120,000 on March 1, 2017, and move to the location of D's new employment. Assuming they lived in the home through the date of sale, they each can exclude $93,750 ($250,000 × 9/24) of their $60,000 share of the gain; thus they recognize no gain.

Part business use

If one or both of the co-owners used part of the residence for business or as a home office before the sale, the Sec. 121 exclusion is still available. No allocation is required to separate the gain allocable to any portion of the property used for business if both the residential and nonresidential portions of the property are within the same dwelling unit.89 The entire amount of the gain is excludable. However, the individual co-owner with the business use must recognize as income (unrecaptured Sec. 1250 gain) any depreciation deductions taken.90 If the business use of the property was separate from the dwelling unit (separate structure), then an allocation is required, and the gain allocable to the nonresidential use must be recognized.91

A gain on a sale that a taxpayer excludes entirely under Sec. 121 need not be reported on the taxpayer's income tax return unless the home was also used for business or income-producing purposes (see IRS Publication 523, Selling Your Home). If there is a taxable gain, the taxpayer should report the sale as a capital gain on Form 8949, Sales and Other Dispositions of Capital Assets. The taxpayer reports depreciation recapture as unrecaptured Sec. 1250 gain on Form 4797, Sales of Business Property.

Tax planning suggestions

When possible, individuals who are jointly liable on the mortgage should consider having the taxpayer who itemizes deductions pay the interest rather than the taxpayer who uses the standard deduction. The itemization versus standard deduction choice is not available for married homeowners. Similar planning can be done with property taxes.

Homeowners should consider the impact of the phaseout of itemized deductions for higher-income taxpayers so that the individual who benefits most from the tax deduction pays the home expense.

Only co-owners who are on the deed should pay the property taxes, as owners are the only parties allowed to take the deduction. Co-owners who are tenants in common should pay their proportionate share of the taxes. Individuals who do pay the taxes can be added to the property title by using a quitclaim deed, allowing them to preserve their deduction. It is important to recognize that a quitclaim deed affects only the ownership of the home, not the mortgage.

Taxpayers should seek the advice of a real estate attorney to make sure they properly structure ownership of the property. Individuals should thoroughly understand the different forms of property ownership at the time they purchase the property. The type of ownership will affect the owner's tax deductions as well as many other rights and responsibilities for the property.

Individuals who are living in a home that is owned and financed by another person may be able to deduct interest paid. To do so the taxpayer must be the equitable owner of the property and demonstrate that ownership by paying all of the home costs. Taxpayers seeking to prove equitable ownership should retain documentation of expenses paid, have a written agreement that specifies the sharing of all home costs, and obtain the testimony of the property's owner to support their case.92

The owners should pay home expenses from their separate funds. They should not use a joint bank account unless they desire equal deductions for the expenses.

Homeowners may deduct property taxes and mortgage interest paid by another individual on their behalf. Typically, the homeowner will be deemed to have received a gift of the amount paid unless the facts indicate otherwise.

Co-owners of the residence, as well as their tax advisers, should be aware of the income and expense consequences that may result from barter transactions within the home. With planning and knowledge, they can adjust the living arrangements to avoid an unpleasant tax surprise.

The Ninth Circuit's decision in Voss allows unmarried co-owners of a residence a larger qualified residence interest limitation deduction than is available to married homeowners. Individuals residing in or outside this circuit should be aware of this potential advantage.

Homeowners who own a property jointly with rights of survivorship must be aware of the potential gift or estate tax consequences that result from the death of a joint owner. Changing the ownership of the property, which the owners may easily accomplish with a quitclaim deed, may result in unexpected gift-tax issues. Individuals are encouraged to consult their tax adviser for assistance with these issues.

The partial-interest rule provides flexibility and planning opportunities for co-owners to exclude gain on sale of their interest in the residence even though another co-owner may not sell or may not qualify for the exclusion. A taxpayer may use a partial sale to sell his or her share of the home, even to another co-owner, before the home appreciation exceeds the exclusion amount. Multiple home co-owners are not limited to the Sec. 121 $500,000 maximum exclusion that applies to married couples filing joint returns.

Unlike those between married individuals, sales of property between unmarried individuals are taxable exchanges, and the individual purchasing a partial interest in property has a cost basis in the partial interest purchased. If the gain on the sale is less than $250,000, the selling individual is able to exclude the gain. Thus, if unmarried co-owners wish to establish a higher basis in the property (e.g., in anticipation of converting a home to rental or business property), they may be able to do so without incurring a tax liability.

Practitioners should remind homeowners planning improvements to take advantage of the residential energy property credit, which is available for property placed in service before 2017. Joint owners who own and occupy the residence may split the credit, but the total credit taken cannot exceed the Sec. 25C limit. The percentage of the credit claimed by each owner is the same as the percentage of the total energy improvement costs paid by that co-owner.

Finally, among the essential elements of any home-sharing arrangement is a well-thought-out and documented agreement. The agreement should consider the liability exposure of the parties. The written agreement should specify the responsibilities and entitlement in the event of death or bankruptcy of any one of them, and there should be a buyout strategy. It is important to remember that, with multiple owners, decisions to sell, refinance, or remodel require the consent of all the parties. These issues should be addressed ahead of time before disagreements emerge.

Conclusion

Rapid changes in the American family structure have altered the image of the traditional household. Households have become more complex, resulting in more individuals who are living together but are not able to use the tax provisions specific to married taxpayers. As the number of nontraditional households rises, awareness is growing about the financial challenges that are specific to them.

To achieve the most beneficial tax result, homeowners and their tax advisers should understand not only the tax rules but also how the home is financed, who owns the home, and who pays the home-related costs. Professional advice provided to the taxpayers before they enter into the transaction can significantly improve the tax results.  

Footnotes

1Regs. Sec. 1.163-1(a).

2Uslu, T.C. Memo. 1997-551.

3Puentes, T.C. Memo. 2013-277; Song, T.C. Memo. 1995-446; Daya, T.C. Memo. 2000-360; Bonkowski, T.C. Memo. 1970-340, aff'd, 458 F.2d 709 (7th Cir. 1972).

4Jackson, T.C. Summ. 2016-33. See similar result in Trans, T.C. Memo. 1999-233.

5Puentes, T.C. Memo. 2013-277, p. *647.

6See discussion of nonrecourse debt in Golder, 604 F.2d 34 (9th Cir. 1979).

7IRS Letter Ruling 5707309730A; Higgins, 16 T.C. 140 (1951).

8Jolson, 3 T.C. 1184, 1186 (1944); Nicodemus, 26 B.T.A. 125 (1932); Neracher, 32 B.T.A. 236 (1935); Finney, T.C. Memo. 1976-329.

9IRS Letter Ruling 5707309730A; Higgins, 16 T.C. 140 (1951); Finney, T.C. Memo. 1976-329; IRS Letter Ruling 201451027; and Rev. Rul. 59-66.

10Rev. Rul. 71-268.

11Chief Counsel Advice 201451027; Neracher, 32 B.T.A. 236 (1935).

12Sec. 461(g)(1).

13Sec. 461(g)(2).

14Rev. Rul. 69-188.

15IRS Letter Ruling 199905033.

16Sec. 63(c)(6)(A).

17Sec. 164(a); Magruder, 316 U.S. 394 (1942); Cramer, 55 T.C. 1125 (1971); Regs. Sec. 1.164-1(a).

18Regs. Sec. 1.164-6(d)(3).

19MacDonald, T.C. Memo. 1976-80; Brooks, T.C. Memo. 1992-63; Lang, T.C. Memo. 2010-286.

20Tuer, T.C. Memo. 1983-441; Seale, 9 Tax Court Memo. 48 (No. 17272, 1/18/50).

21MacDonald, T.C. Memo. 1976-80; Small, 27 B.T.A. 1219 (1933); Kohlsaat, 40 B.T.A. 528 (1939).

22Rev. Rul. 71-268.

23See, e.g., Nicodemus, 26 B.T.A 125 (1932); Rev. Rul. 72-79; Rev. Rul. 71-268. State law should be consulted to determine liability for jointly owned property. Community property states are not discussed in this article because the focus is on unmarried joint owners.

24Cothran, 57 T.C. 296 (1971).

25Burden, T.C. Memo. No. 107611 (1943).

26Smith, 135 F. Supp. 694, and Blunt, T.C. Memo. 1966-280.

27Powell, T.C. Memo. 1967-32.

28Peters, T.C. Memo. 1970-314; Estate of Movius, 22 T.C. 391 (1954).

29Peters, T.C. Memo. 1970-314.

30Regs. Secs. 25.2511-1(a), (c)(1), (h)(2), and (h)(3).

31Lang, T.C. Memo. 2010-286.

32Cramer, 55 T.C. 1125 (1971); Brooks, T.C. Memo. 1992-63.

33$14,000 for 2017 (Rev. Proc. 2016-55; Sec. 2503).

34See, e.g., Nelson, 281 F.2d 1 (5th Cir. 1960); Rushing, 58 T.C. 996 (1972); and Eskimo Pie Corp., 4 T.C. 669 (1945), aff'd, 153 F.2d 301 (3d Cir. 1946).

35Sparks Farm, Inc., T.C. Memo. 1988-492. See also Rev. Rul. 71-179, where a father who co-signed his son's student loan was allowed to deduct the interest he paid.

36Stratmore, 785 F.2d 419 (3d Cir 1986), and Putman, 352 U.S. 82 (1956).

37Sherman, 18 T.C. 746 (1952).

38Voss, 796 F.3d 1051 (9th Cir. 2015), rev'g Sophy, 138 T.C. 204 (2012).

39Action on Decision 2016-02.

40Sec. 163(h)(3)(B)(ii) and Sec. 163(h)(3)(C)(ii).

41Regs. Sec. 1.6050H-1(b)(3). Lenders also report points paid in connection with the purchase of the borrower's residence on Form 1098 (Regs. Sec. 1.6050-1(f)(1)).

42Secs. 165(h)(1) and (2).

43Regs. Sec. 1.165-7(b)(1).

44Regs. Sec. 1.165-7(a)(1); Sec. 165(i) and Regs. Sec. 1.165-11. Individuals may not claim a deduction for insured property unless a timely insurance claim is filed per Sec. 165(h)(4)(E).

45Draper, 15 T.C. 135 (1950).

46Id.

47Rev. Rul. 75-347; Kraus, 10 CCH TCM 1071 (1951).

48Kraus, 10 CCH TCM 1071 (1951); Loewenstein, T.C. Memo. 1968-227.

49Regs. Sec. 1.165-7(b)(4)(iii).

50Regs. Sec. 1.165-7(b)(4)(iii).

51Sec. 1033(a)(1).

52Sec. 1033(a)(2)(A).

53Sec. 1033(b)(2).

54Sec. 1033(a)(2)(B); several special rules apply, for example, for condemned real property and federally declared disaster areas.

55Rev. Rul. 74-273.

56IRS Letter Ruling 8429004.

57Sec. 121(d)(5) and Chief Counsel Advice 200734021. See this CCA for further explanation of complete destruction and when repairs to the existing home may qualify.

58Sec. 121(d)(5)(B) and Regs. Sec. 1.121-4(d) and Example (4).

59See Regs. Sec. 1.121-4(d)(4).

60Regs. Sec. 1.61-2(d)(1); Rev. Rul. 79-24.

61Sec. 212; Regs. Sec. 1.212-1(h).

62See IRS Publication 597, Residential Rental Property.

63Sec. 102(a).

64Sec. 102(c).

65McManus, T.C. Memo. 1964-43; Estate of Daly, 3 B.T.A. 1042 (1926).

66Duberstein, 363 U.S. 278 (1960); Lane, 286 F.3d 723 (4th Cir. 2002).

67Goodman, 6 CCH TCM 1031.

68Sec. 102(a).

69Sec. 163(h)(3)(B)(i)(II); Temp. Regs. Sec. 1.163-10T(o).

70Sec. 163(h)(4)(A)(i)(II) and Sec. 163(d).

71Most of the issues discussed throughout this article apply to owning a home with any family member, including but not limited to parents.

72Sec. 163(d)(1).

73Secs. 262 and 212.

74Estate of Boyd, 28 T.C. 564 (1957). Tenants in common share necessary expenses for maintenance and repairs to common property in proportion to their ownership.

75Sec. 121(a).

76Regs. Sec. 1.121-1(c)(1).

77Regs. Sec. 1.121-2(a)(2).

78Regs. Sec. 1.121-2(a)(4), Example (1).

79Regs. Sec. 1.121-2(b).

80Regs. Sec. 1.121-2(a)(4), Example (1).

81Temp. Regs. Sec. 1.1041-1T(d).

82Regs. Sec. 1.121-4(e)(1)(i).

83Regs. Sec. 1.121-4(e)(1)(ii)(A).

84Regs. Sec. 1.121-4(e)(3), Example.

85Regs. Sec. 1.121-4(e)(1)(ii)(B).

86Regs. Secs. 1.121-1(b)(1) and (b)(2). Regs. Sec. 1.121-1(b)(2) says that the home a taxpayer uses for the majority of time during the year will be considered his or her principal residence for that year.

87Regs. Secs. 1.121-3(c)(1), (d)(1), and (e)(1).

88Regs. Sec. 1.121-3(f)(5).

89Regs. Sec. 1.121-1(e)(1).

90Sec. 121(d)(6); Regs. Sec. 1.121-1(d).

91Regs. Sec. 1.121(e)(1).

92See the recent case of Jackson, T.C. Summ. 2016-33, which outlines the factors necessary to demonstrate equitable ownership.

 

Contributors

Claudia L. Kelley is a professor and C. Kevin Eller is an assistant professor in the Walker College of Business at Appalachian State University in Boone, N.C. For more information about this column, contact thetaxadviser@aicpa.org.

 

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