The Section 121 exclusion is a great tax benefit for homeowners. It allows them to exclude taxes on gains up to a certain amount if they meet the Section 121 criteria. That’s nice for homeowners, but what if the home is within an estate? Does the home still get the exclusion?
The Section 121 exclusion states that if a person has lived in their primary residence for 2 out of 5 years, they can exclude taxes on gains of up to $250,000 if filing single or $500,000 if filing jointly.
Section 121 applies to primary residences and not investment properties. An ownership and use test must be met for the exclusion to qualify. These tests ensure that the home was, in fact, lived in as a primary for 2 of the 5 years.
Section 121 doesn’t mean the home can’t be rented during the 5 years. For example, a homeowner might live in the home for 2 years and rent it out for 3.
To see how the exclusion works, let’s look at another example. In this one, a single tax filer buys a home for $1 million. They apply $150,000 in upgrades. After living in the home for 3 of the last 6 years, the home is sold for $1.5 million, resulting in a gain of $350,000.
In this case, the Section 121 exclusion has been met. Only $100,000 (350,000 - 250,000) of gains will be taxed. Additionally, these gains will be taxed at the long-term capital gains rate.
Partial exclusions are also possible if a homeowner moves out of the home before meeting the full exclusion.
Is it possible for an estate to take advantage of the Section 121 exclusion? This depends on what we mean by estate. The term by itself is very broad. It can apply to a will, probate, trusts, joint tenants (right of survivorship), transfer on death deed, and more. And each of these types of estates can vary in how they were set up. So, estates are a bit like individual tax returns in that each is unique.
To simplify the term estate, we’ll use it in the context of trusts. Now the question is, does the Section 121 exclusion apply to a home within a trust? There’s a specific section in the Section 121 exclusion called 1.121-1(C)(3)(I). It states:
Trusts. If a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.
From this we can see that a trust can in fact receive the Section 121 exclusion under certain conditions. But given the complexities involved with estates, it’s best to work with a tax and estate attorney to verify that the estate does meet the exclusion.
Is it possible to get the Section 121 exclusion while also getting a tax deferral through a 1031 exchange? The Section 121 exclusion applies to a primary residence, while a 1031 exchange applies to an investment property. So, it would seem we have a conflict.
But not so fast. Suppose the property is a residence/investment mixed dwelling such as a duplex, triplex, mother-in-law unit over a detached garage, or a home with a basement with independent access. In all cases, the homeowner still lives on the property. In that case, it can utilize Section 121 and a 1031 exchange.
For example, the homeowner lives in one unit of a duplex while renting out the other. Section 121 would apply to the homeowner’s unit, while the 1031 exchange would apply to the rented unit. Another example may involve farm property. The property has a farmhouse, and the rest is an investment (i.e., a working farm). The farmhouse may meet Section 121, while the rest of the property qualifies for a 1031 exchange.
There are other Section 121 and 1031 exchange combination scenarios that deal with converting a residence into an investment property and vice versa.
Of course, these are also complex scenarios. It's best to work with a tax specialist to ensure you can meet the rules for these tax benefits.