Exploring IRS Section 121- Excluded Gain On Sale Of Residence- Part 1 of 4- Overview
Taxpayers can exclude up to $500,000 of capital gains on the sale of a primary residence under IRC Section 121. Section 121 exclusion can be used as often as once every 2 years; the planning opportunity is quite significant for those with large rental real estate holdings. This creates an appealing tax planning opportunity – to convert rental real estate into a primary residence, in an effort to take advantage of the capital gains exclusion to shelter all of the cumulative gains associated with the real estate.
To prevent abuse , Congress has enacted several changes to IRC Section 121 over the past 15 years, preventing depreciation recapture from being eligible for favorable treatment, requiring a longer holding period for rental property acquired in a 1031 exchange, and more recently forcing gains to be allocated between periods of “qualifying” and “non-qualifying” use.
This present some valuable opportunities for real estate investors who do have the flexibility to change their primary residence in an effort to shelter capital gains on long-standing real estate properties.
Rules For Excluding Gain On Sale Of Residence
The Taxpayer Relief Act of 1997 created IRC Section 121, which allows a homeowner is allowed to exclude up to $250,000 of gain on the sale of a primary residence (or up to $500,000 for a married couple filing jointly). To qualify, the homeowner(s) must own and also use the home as a primary residence for at least 2 of the past 5 years. In the case of a married couple, the requirement is satisfied as long as either spouse owns the property, though both must use it as a primary residence to qualify for the full $500,000 joint exclusion.
Please note, the use does not have to be the final 2 years, just in any 2 years of the past 5 years that the property was owned. For instance, if an individual bought the property in 2012, lived in it until 2014, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2017, the gains are still eligible for the exclusion because in the past 5 years (since 2012) the property was used as a primary residence for at least 2 years (from 2012-2013). The fact that it was no longer the primary residence at the time of sale is permissible, as long as the 2-of-5 rule is otherwise met.
If a sale occurs and it has been less than 2 years, a partial exclusion may still be available if the reason for the sale is due to a change in health, place of employment, or some other “unforeseen circumstance” that necessitated the sale. In such scenarios, a pro-rata amount of the exclusion is available; for instance, if a married couple had to sell the home after 16 months instead of the usual 24, the available exclusion would be 16/24ths multiplied by the $500,000 maximum exclusion, which would provide a $333,333 maximum exclusion.
The capital gains exclusion is only allowed once every 2 years. Thus, the partial exclusion still cannot be used if another exclusion had been claimed for another sale in the past 24 months. In the event of a married couple the full $500,000 exclusion is only available as long as neither spouse has used it in the past 2 years (if one spouse sold a home recently and the other did not, the second spouse can still use his/her individual $250,000 exclusion). On the other hand, as long as “no more than once every 2 years” requirement is met, there is no limit on home many times an individual can take advantage of the primary residence capital gains exclusion throughout their lifetime!