How to Use the Section 121 Exclusion to Save Thousands in Taxes

Since we are talking about IRS tax code today, I will start this post out with a quick disclaimer that I am not a CPA, or Tax Attorney, or other tax professional.  Please don't take this information as tax advice as every persons situation will vary and tax laws change frequently,  This is a compilation of information that I gathered while doing my own research on selling my primary residence.

With that out of the way, let's answer the question; What is the Section 121 exclusion?  Section 121 of the Internal Revenue Code allows a taxpayer to exclude up to $250,000 ($500,000 if filing a joint return) of the gain from the sale of property owned and used as a principal residence for at least two of the five years before the sale.  This can be a massive tax savings when selling a property that has appreciated greatly in value.

Here are some of the fine print details of Section 121:

• You don't have to reinvest the gains from the sale into another home.  (this was the previous requirement)
• The two year residence requirement does not have to be the final two years before sale as long as it was the principal residence for two of the previous five years.
• You can only use the full exclusion once every two years.  If you have to move sooner due to a change in employment, or health, a partial exclusion may be available.
• If you have more than one home, the regulations will usually require you to claim the one where you spend the most time residing as your principal residence.
• To satisfy the principal residence requirement, you must physically occupy the property two years.  Vacations and short temporary absences still count as occupied use even if you rent the home during these short periods.
• Gains that are greater than the exclusion allows for are taxed at the Capital Gains tax rate.  Long term (owned for more than one year) Capital Gains rate are currently either 15% or 20% depending on your income.

If use of the home has been mixed between principal residence and rental property or business property, things get a little bit trickier.  Here are the high level details of what the code says about this:

• If the property was used as a rental and you claimed depreciation expenses, those expenses are still fully taxable as Depreciation Recapture.  This recapture is taxed at your ordinary income tax rate but is currently capped at 25%.
• If the property was used as a rental and you converted it to your principal residence, you will have to figure the ratio of qualified to non-qualified use and multiply the gain by this percentage to come up with your exclusion amount.
  • Any use previous to 2009 is considered "qualified" whether it was a rental or a principal residence.
  • Example: If you rented out your property from 2010-2016 and then moved into it from 2017-2018 to satisfy the 2 out of 5 year requirement, you would have to divide two (years of qualified use) by six (total years of ownership).  This gives you a percentage of 33%.  Only 33% of the gain would be qualified for the Section 121 exclusion.
• If you have been claiming a deduction on part of the house for business (usually home office deduction), only the part of the home attributable to the residential portion can be excluded.

Of course, as with all Internal Revenue Code topics, there are many more nuances and details that may affect a particular situation.  This should get you started so that you can have a conversation with your tax planning professional to make sure that you can qualify the maximum exclusion that you can get.  An opportunity to not pay tax on $250,000 - $500,000 doesn't come along often so don't miss this one.

As always, please reach out to me via email or the comments section below with any questions or to discuss how we can work together to grow our financial futures through real estate investments.

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