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Sale of Residence Has Special Tax Rules

By:Robert Moore, Thursday, September 14th, 2023

Legal Groundwork

Your residence is one of the few assets that can be sold for a gain without creating tax liability.  The IRS rules allow $250,000/person of gain from the sale of a residence to be excluded from income.  This rule is why most people do not need to worry about capital gains taxes when they sell one residence to buy another.  This exception to capital gains taxes is important when considering business structures for the farming operation and when buying/selling a farm with a residence.

To qualify for the $250,000 residence exemption, the residence being sold must have been owned and used as the primary residence for two of the last five years.  Houses that have not been used as the residence or that were acquired through a like-kind exchange are not eligible.  For married couples, each spouse is eligible for the $250,000 deduction for a total of $500,000.

Consider the following example:

Andy and Betty purchased a house in 2000 for $200,000.  They used the house as their residence until 2023 when they sold it and moved into a retirement community.  The sale price for their house as $500,000.  Assuming they otherwise qualify, there will be no tax on the sale of the house.  The transaction creates a $300,000 gain but Andy and Betty may reduce their income by $300,000 to match the gain.   Therefore, there is effectively no tax on the gain and Andy and Betty will receive the entire $500,000 sale price free of capital gain taxes.

The residence exemption has many implications but for farm families two come to the forefront.  The first involves the sale of a farm that includes the residence.  The $250,000 exemption only applies to the residential “curtilage” – the land immediately surrounding the residence and any closely associates buildings or structures.  Generally, this means that the residence can include a lawn area, garage, storage shed and similar structures.  The exemption does not apply acreage adjacent to the residence that is used to grow crops.

When selling a farm with the residence, the sale price should be allocated between the residence and farmland.  As much of the sale price as can be legitimately justified should be allocated to the residence because this amount, up to $250,000, will not be taxed.  Again, the allocation should be consistent with the true value of the residence.

Consider the following example:

Carl and Diane decide to sell their 80-acre farm for $1,000,000.  The farm includes their residence and 80 acres.  When negotiating with the buyer, they agree to allocate $300,000 of the sale price to the residence and 1 acre and $700,000 to the 79 acres used as farmland.  Provided the residence otherwise qualifies, the $300,000 will not be taxed but the $700,000 will likely have capital gain taxes.

Carl and Diane may be tempted to try to use their entire $500,000 exemption on the sale.  They should only take the entire exemption if they can justify valuing the residence and curtilage at $500,000.  An appraisal may be appropriate if using the maximum exemption.  Also, Carl and Diane cannot include 20 acres of the farmland with the residence to justify using a $500,000 value.  Any part of the 80 acres that is used to plant crops will not be considered part of the curtilage and will not be eligible for the residential exemption.

Another situation where the residential exemption may arise involves establishing land LLCs.  Many farm operations have an LLC or other business entity to hold the farmland and/or farm facilities.  Land LLCs provide many benefits including liability protection and preventing land transfers outside of the family.  The issue that arises with land LLCs is that LLCs do not live in homes so are not eligible for the residence deduction.  That is, only people can receive the residence deduction, not business entities.

A farmer’s residence is often part of a larger parcel that includes farmland and/or farm facilities.  Before transferring the parcel with the residence to an LLC, careful consideration should be made as to the implications to the residence tax exemption.  In some cases, the residence should be surveyed off and remain owned by the original owners.  In other cases, it may not be feasible to survey the residence from the farm and/or it may be very unlikely that the residence is ever sold.  The decision to transfer or not transfer the residence to an LLC should be made on a case-by-case basis.

Consider the following example:

Earl and Fran own 500 acres of farmland.  As part of their farm succession planning, they decide to transfer their land to an LLC.  The 500 acres include their residence and their “home base” – shop, bins and other buildings used in the farming operation.  Their residence sits in the middle of home base and would not be feasible to survey it from the rest of the farm.  Also, Earl and Fran are unlikely to ever sell the residence because their children will be taking over the farm and the residence is likely to stay within the family for at least another generation.

In this situation, Earl and Fran decide to transfer their residence to the LLC.  They will lose the residential exemption but because it is not feasible to survey off and they are unlikely to ever sell the residence, they are willing to forgo the exemption.

Let’s change the scenario a bit to see how the residential exemption can be preserved.  Earl and Fran’s residence is located in the corner of a parcel away from home base.  Before Earl and Fran transfer the land to an LLC, they survey off their residence and one acre.  They keep the residence and one acre in their name and transfer the remaining 499 acres to the LLC.

In this scenario, Earl and Fran have preserved the residential exemption.  If they sell their home in the future, they will be eligible to deduct up to $500,000 of gain.  The extra cost of a survey is worth preserving the exemption.

It should be noted that it is possible to transfer a residence to a single-member LLC and maintain the residential tax exemption.  The IRS considers most single-member LLCs to be the same as the owner.  So, in the above example, the residence could be transferred to an LLC and the residential exemption kept as long as only Earl or Fran is the owner of the LLC – although the exemption may be limited to only a single, $250,000 exemption.

The residential exemption for sales can save considerable taxes when selling a home.  When selling the residence with a farm, as much of the purchase price as reasonable should be allocated to the residence.  If transferring farmland to an LLC, the residence should remain outside of the LLC if possible and/or if the residence is likely to be sold in the future.  Like most tax and legal issues, there are exemptions, exemptions to the exemptions and nuances that must be addressed for each individual situation.  Be sure to consult with a tax and legal professional for guidance on the rules and regulations regarding the sale or transfer of your residence.