Exploring IRS Section 121- Excluded Gain On Sale Of Residence- Part 4 of 4- Planning Implications of Section 121 Primary Residence Gain Exclusions
The Taxpayer Relief Act of 1997 created IRC Section 121, which allows a homeowner 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). In order 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.
The use does not have to be the final 2 years, just any of the past 2-in-5 years that the property was owned. Thus, for instance, if an individual bought the property in 2010, lived in it until 2012, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2014, the gains are still eligible for the exclusion because in the past 5 years (since 2010) the property was used as a primary residence for at least 2 years (from 2010-2012). 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 an individual had to sell the home after 18 months instead of the usual 24, the available exclusion would be 18/24ths multiplied by the $250,000 maximum exclusion, which would provide a $187,500 maximum exclusion (which will likely still be more than enough, as it’s unlikely that the gain would be more than this amount unless it was an extremely large house!).
Planning Implications Of Section 121 Primary Residence Gain Exclusions
The Section 121 exclusion of capital gains on the sale of a primary residence is one of the most favorable tax preferences under the Internal Revenue Code, given both the sheer magnitude of the gains that can be excluded, and the fact that there is no limit to how many times it can be taken (beyond the limit of no more than once every 2 years).
Of course, from a practical perspective, many individuals and couples treat their home as a home, and not as an ongoing chain of serial real estate investments from which tax-free capital gains can be harvested as long as they live in it for at least 2 years first (which in reality is why Congress allows such favorable provisions in the first place). While a few clients might actually be inclined to move repeatedly from one property to the next – taking advantage of the capital gains exclusion every 2 years – this will not likely be a popular strategy for a few.
Given that most clients will probably only have an opportunity to take advantage of these rules a couple of times throughout a lifetime, it becomes all the more important to properly plan in the first place to ensure the exclusion will be available. This may include having clear documentation to show exactly when the property was used as a primary residence (especially if it may not be the full 2-year period and the pro-rata partial exclusion may apply, or if there are periods of qualifying and non-qualifying use) It is also important for planning around using the exclusion in the event of death or divorce of a spouse (in both situations, ownership and use of a deceased spouse or an ex-spouse can potentially be ‘tacked on’ to the subsequent owner to qualify for the exclusion). In the case of newly married couples, this may include additional coordination if either (or especially if both) previously owned a primary residence, and wish to sequence their sales to allow the maximal exclusion (for instance, one spouse sells one property for a $250,000 exclusion, both move into the other property for 2 years, and then the couple sells the second property for a $500,000 exclusion).
For clients that are more active real estate investors, there may be significant appeal to more proactively taking advantage of the primary residence exclusion rules, notwithstanding the limitations on non-qualifying use, especially in light of the fact that gain is always assumed to be allocated pro-rata across all the years, and not necessarily based on when gains actually occurred. This effectively creates an incentive for property that has rapidly appreciated during its rental period to be converted into a primary residence, even if the appreciation rate will slow.
Example. Donald purchased a rental property in early 2009 at the market bottom for $400,000, and it has appreciated in the 5 years since to $750,000. If Donald sells his current house, and moves into the rental property now to make it a new primary residence and sells it in 2 years for $775,000, the total gains above original cost will be $375,000. Since Donald will have 2/7 years of qualifying use, he will be eligible to exclude 2/7 * $375,000 = $107,143 of capital gains, even though the actual gains during his time living in the property were only $25,000. In addition, Donald will have been able to benefit from the capital gains exclusion on his prior home (sold 2 years ago), and the capital gains exclusion again on this rental-property-converted-to-primary-home, as long as the sales are at least 2 years apart. (Alternatively, if Donald had not sold his prior residence, he could have simply held it throughout, and then moved back into the original property and continued its use as a primary residence, though there would now be 2 intervening years of non-qualifying use for that property.)
Given that non-qualifying use only counts for such use since 2009, real estate investors may find it most appealing to move into older rental real estate properties that have a significant amount of gains that can be allocated prior to 2009 (where even though it was rental property, it doesn’t count as non-qualifying use). The qualifying/non-qualifying use rules will make the strategy less appealing for most real estate investors on a forward-looking basis, though planning opportunities remain in the aforementioned scenarios where rapid appreciation during non-qualifying use periods can be sheltered by subsequent qualifying use when there is slower growth (effectively shifting income from the less favorable time period to the more-tax-favored one).
In the case of properties that have been converted from a primary residence into rental real estate, the key planning issue is to recognize that there is a limited time window when a property can be rental real estate but still be eligible for the Section 121 exclusion – eventually, the property is rental real estate so long, the owner will no longer meet the 2-of-5 use-as-a-primary-residence test. For instance, in the earlier Example 3, Donna can only rent the property for up to 3 years after living there as a primary residence, before she can sell it and claim the Section 121 exclusion (or risk moving beyond the 2-of-5 years’ time window).
The bottom line, though, is simply this: for those who are more flexible about their primary residence living arrangements, and move more frequently (or are often forced to do so by job/life circumstances) there are significant tax planning opportunities available thanks to the Section 121 capital gains exclusion on a primary residence. For clients who are more active real estate investors, and have the flexibility to convert rental properties into primary residences, additional opportunities apply to navigate the non-qualifying use rules (and/or simply recognize that pre-2009 rental use won’t be counted against the owner as non-qualifying use in the first place!). However, because of the stringency of the rules – and the magnitude of the capital gains taxes that may be due if a mistake is made – it’s crucial to follow the rules appropriately to gain the maximum benefit (or any benefit at all!)