What Constitutes a Primary Residence?
Primary residence refers to the real property that a person occupies as their primary home and, in most cases, is subject to all California homestead exemptions. Usually this is the home in which the taxpayer lives for the greater part of the year. In California for example primary residency would entitle the homeowner to $75,000 in protected equity if a single filing head of household and an additional $100,000 for each dependent in residence not to exceed $1,000,000 in equity under California Tenants Right to Sale Act of 1976. Calif. Civil Code §704.950 (a)(1)(A).
Having primary residence status typically makes the home exempt from a forced sale until the value of the home exceeds the homestead protection amounts stated above. The equity above the homestead protection can be exempted to certain extent if the homeowner has another type of exemption to apply against the equity. Primarily , the homeowner can keep an unlimited amount of money if he can show he used the money to buy a new primary residence or improve upon the existing primary residence. The amount of money used towards the home purchase can be made exempt by the homeowner under California homestead exemption statutes. In addition, homestead exemptions vary by state, and California has one of the highest homestead exemption amounts in the United States.
Primary residence is also used by the I.R.S. to determine whether a homeowner can use a "Like-Kind Exchange" on the appreciated real property. A primary residence trade must be exchanged "exclusively for property of like-kind" to qualify as a like-kind exchange under Internal Revenue Code § 1031. Basically, structures and land are interchangeable for other structures and land provided they are like kind. In California, more than one parcel of land can be combined so that tax deferred like kind exchanges do not have to be duplicated. Calif. Revenue & Taxation Codel § 17506.
California’s Standards for Primary Residence
California has established a series of criteria to determine whether an individual dwells in a home as his or her primary residence. When such a provision exists in your state, and you are using a trust to hold title, it is crucial that the trustee be aware of how the state’s residence laws may apply to the trust.
Generally speaking, an individual must occupy the residence as his or her primary residence for a minimum of two months every year. California’s guidelines state that the property must be "occupied by the claimant for at least 50 percent of the time that the unit is rented out or available for rent." Conversely, the trust agreement must clearly define how long the trust beneficiary is allowed to be absent from the residence without losing any potential opportunity to return and re-occupy the home. Individuals who do not use the home as their primary residence for at least two months in each calendar year are said to lose their ability to return and reside within the property. In other words, the home is not considered a primary residence and the trustee should consider the implications of that fact.
One interesting twist to California’s residence rule is that the state has a 2632-day rule which allows the owner to be absent for as many as 2632 days, or seven years in total, before the residence is no longer considered a primary residence and the trustee must treat it as a second home for trust purposes. This is particularly important when dealing with estate issues, such as figuring out how much trust property is available for estate-tax purposes. Other states have built in similar provisions, though Nevada is one of a handful of states that has no such clause. Failure to address these details regarding secondary property status can have significant ramifications later, if the trustee fails to disclose the appropriate data and witnesses a problematic tax scenario unfold as a result.
Taxes Associated with Primary Residence Designations
Establishing the primary residence in California has a number of tax benefits that homeowners should be aware of. The most significant savings are generally seen on property taxes and capital gains tax.
If an individual’s primary residence is located in California, he or she is subject to Proposition 13, a constitutional amendment limiting the property tax rate for that home to one percent of the assessed value, plus an annual increase of no more than two percent of that value. The assessed value is not permitted to increase based on the current market value of the property and, as a result, the assessed value of even long term residents is oftentimes far below the current market value. When the primary residence is sold, however, the above protections cease and the property is reassessed for property tax purposes at the higher of its market value or its owner’s basis (usually the purchase price).
Although the above provision minimizes the property tax pain for long term homeowners, California law also provides some relief in the event a primary residence is sold. Currently, if an individual sells his or her primary residence in California for an amount greater than the owner’s basis in that property, this "gain" will generally not be subject to taxation for federal income tax purposes if the owner complies with the provisions of IRC §121. The IRC section requires that the owner live in the primary residence for at least two of the last five years before the sale, that the primary residence be the only residence owned by the taxpayer during the two-year period, and that the homeowner used the property as a primary residence on the sale date. In addition, the IRC §121 exclusion is available to both single and married taxpayers and, in the case of married taxpayers, the couple my choose between an exclusion of $250,000 per spouse or double the regular exclusion (i.e., $500,000, with the exclusion potentially reduced for allocable gain on the sale of a residence previously excluded under IRC §121 in the prior two years).
Legal Implications of a Primary Residence
When it comes to real property transactions, both buyers and sellers often designate a primary residence on some of the most common and routine documents. Whether it’s a Purchase Agreement, Grant Deed, or Grant Bargain and Sale Deed, there is often a box checked somewhere in each transaction that indicates which property is the primary residence. While most real estate professionals know that "a property being designated a primary residence" can provide numerous benefits to home owners, few buyers and sellers actually analyze the consequences of declaring their property as such. In addition to the tax benefits, there is also the important issue of insurance.
One of the most obvious reasons for designating a primary residence is to take advantage of the capital gains exclusion provisions in Internal Revenue Code section 121. The pertinent portions of the statute states:
(a) In General – 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 –
(1) such property has been owned by the taxpayer for periods aggregating 2 years or more, and
(2) such property has been used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.
However, there are also times when instances of fraud can occur – often unbeknownst to the unsuspecting homeowner. For example, an unsuspecting homeowner may sign a Grant Deed under false or fraudulent pretenses – claiming that the buyer is going to be the owner occupant when in reality the immediate goal is to resell the property for a profit. If the fraud is uncovered, the consequence of the misrepresentation is that the buyer then cannot qualify for the Capital Gains Exclusion provided under federal tax law.
Moreover, the issue of insurance can also have significant legal consequences. Without proper designations, homeowners may invalidate coverage on their homeowner policy. For example, if a homeowner rents out their property, but sells it as their primary residence, they are at risk of having their insurance company deny a claim for coverage on their policy.
As the California Court of Appeal noted in Leicester v. Blue Shield of California (1981) 121 Cal.App.3d 264, 272:
"in the absence of any statutory provision requiring [an insurer] to cover the building [housing a professional office] – a building not covered by plaintiffs’ policy – [the insurer] was not bound to extend coverage to this structure". Clearly it is not in the best interest of the homeowner to misrepresent themselves on legal documentation concerning the primary residence.
Altering One’s Primary Residence in California
Under California law, it has always been true that people may change where their "principal place of residence" is located. (See CAL. CIVIL CODE § 1942.5). This means that a person’s "primary residence" need not be a particular address and that a principal place of residence can be changed by merely moving from one property to another with the intent to reside at the new property as one’s primary residence. However, there are legal limitations on that authority. There are rules which govern: Why do we have these rules? Well, the rules against treating rental properties as a primary residence (to achieve a primary residence tax reduction) has generally been due taxation issues (e.g., the State does not want a person to pay a lower tax rate on an owner-occupied property only to have that property rented out as an investment property). Also, having a primary residence basis which allows a property to be "over rented" to income fellows can cause rent control evictions to be very difficult assuming you haven’t lived there within the last three years. Thus in order to stop rent control evictions from being used by disqualified people (e.g., those who should not be occupying the rental unit, like the landlord’s aging grandmother) some cities have altered the definition of a primary residence for rent control purposes to include living in a unit for 181 days [or about six months] during the prior year. See e.g., S. Y. Property Management v. Lee , 62 Cal. App. 5th 1002 (2021). Now while the law doesn’t preclude an owner from changing their principal place of residence any time they want, generally the Courts have held that if an owner moves out of a rental and the property is rented out to another tenant, then the 181 day rule works to allow the tenant to stay in the rental unit. Please note that statutes only govern the disqualification of a primary residence for the tax benefit assessment, thus if you leave for not more than six months and return (even having rented the property while gone), Courts are likely to assume that you are back to live where your heart allows you. If you intend to change the place where your heart resides (or your principal place of residence), consider informing the City governing the building where you live that you have moved to a new location. If the building is subject to rent control, you may want to consider notifying the old place of your departure, your new location and a request that the property no longer be designated as your principal place of residence. Moreover, when you do move in to your new place, you may want to inform the city in which you plan to reside of your new residence. This is especially true if you live in a city that requires permits to continue occupancy after a period of time. (e.g., San Francisco and Los Angeles). These articles cover information about principal places of residence and rent control, so if you have any further questions about it, do not hesitate to reach out.
Myths Surrounding Primary Residence Requirements
Many people mistakenly believe that you cannot own a second or third residence and still qualify as a primary of principal residence if the first property is not generating rental income. While it is true that generating rental income on a second, third or additional property may suggest to the taxing authorities that you are not using the property as a primary residence, the determination often turns on other factors, such as the amount of time spent at the property and your intent to use the property as a primary residence.
Many people mistakenly believe that they can have different primary residences for tax purposes as long as they meet the required residency tests in each location they claim as their primary residence. In fact, under the residency tests set forth in the various taxing statutes, a taxpayer can only have one primary residence at any given time. If you sell more than one home in a single year and only maintain your primary residence for a short period of the year, you may be violating the single primary residence rule.
Many people mistakenly believe that they may transfer property from one spouse to another between family members as part of an estate planning tool and receive the benefit of the exclusion of any appreciation in value of the transferred property. The step up in basis for property owned by a married couple only applies to properly transferred property. Executors or personal representatives of estates have limited authority to distribute property held by husband and wife to the decedent’s estate and to provide for the transfer of the property to the surviving spouse without the need to file a gift tax return. The executor or personal representative must make certain the transfer is completed before the estate of the deceased spouse is closed otherwise the appreciation in value of the asset after the death of the first spouse may be subject to capital gains tax when the survivor sells the property.
Many people mistakenly believe that they can use the primary residence exclusion for a principal residence they never move into or use for other than short rental periods. Residential property, whether owner occupied or rented, cannot be treated as a principal residence unless it is used for residential purposes. This includes residential real property used for rental purposes if the property is rented out to tenants for a longer or shorter term basis. Rentals for a period less than 14 days per year and family use for more than 14 days per year are not considered homestead or principal residence property for purposes of taxation.
Many people mistakenly believe that they may convert their primary residence, or one or more of their rental properties to their primary residence, in order to save future capital gains taxes. Individuals who own multiple properties and choose to sell one property over another can save taxes on the second and subsequent property sold by making sure that the property which qualifies for the exclusion of the capital gains tax is the property which is sold. This is a timing issue which needs to be addressed at the earliest stages of an estate planning process, as there is no longer a 2-year waiting period for the owner to reside in the property and the waiting period requirement is now set forth in terms of the change in intent to reside in the property.
Cases and Legal Precedents
In Jones v. Department of Finance, 128 Cal. App. 4th 1042 (2005), a retired San Diego school teacher bought a home in Big Bear Lake District, inspected it herself, saw only the upstairs unit as she believed the downstairs unit was vacant, did not disclose any material problems of the unit, and no inspection was required due to the condition of the property. In 1996, the second unit was the actual residence of the Joneses, but there was probably rental income from the downstairs unit. The County reassessed the property, determined that it had been unoccupied as of Jan. 1, 2001, and taxed the Joneses on the property as commercial industrial. The Joneses paid the increased taxes under protest. Both the superior court and appellate court said that the property was not used for family living, which supported the tax assessment of the entire property as commercial industrial.
The case of Chapman v. Burns, 31 Cal. App. 5th 661 (2018) (as modified on denial of reconsideration), provides an interesting distinction from the Jones case, when it involves two identical duplexes. In this case, the second duplex was used as a rental house, rather than a family home, while the first duplex was used as a single family home. The court ruled that the first duplex was reduced by 15% to 29% of its assessed value , as it could have been sold as a condo. But, the second duplex was assessed with a much smaller reduction, and the parties settled the case where the second duplex was given a 15% reduction.
A number of cases have been decided under California Civil Code Section 26, called the "in residence" rule. In those cases, the courts held that if the property was not occupied, it was not eligible as a residence and nonoccupied properties should be taxed as "vacant land," which is often more than double the residential rate. As a result of these cases, appraisal districts aggressively pursued properties as "not-in-residence." Republicans in the state legislature, concerned about elderly people losing their properties because they were using out-of-state care facilities, proposed what is called the "Mack fee," by which these elderly people could pay a fee to stay in their homes.
In Moses v. Borzoi, 211 Cal. App. 4th 1221 (2012), a commercial-industrial assessment of a home triggered the first of what are now hundreds of legal cases throughout the state of California to challenge the other way of assessing real estate, which is called a "full cash value basis."