Section 121 of the Internal Revenue Code allows taxpayers to exclude from income some of the gains they have enjoyed due to the increase in value of a primary residence. The IRS rules are meant to support the exclusion by homeowners while denying it in the case of an investment property. To that end, taxpayers claiming the exclusion must satisfy both an ownership and use test.
What does Section 121 allow?
Section 121 of the IRC has evolved over the last century to its present Form. Currently, a taxpayer filing individually can exclude a gain of up to $250,000 in capital gains when they sell their primary residence. A married couple is allowed $500,000. However, there are two significant qualifications:
- The taxpayer must have owned the property for two of the most recent five years.
- The taxpayer must have lived primarily in the property for at least two of the past five years.
In most cases, taxpayers seeking the exclusion allowance have likely lived in and owned the home for concurrent periods that satisfy these requirements. However, while the ownership must immediately precede the sale, the residency is not subject to the exact conditions. For example, perhaps you have owned a home for eight years but initially used it as a vacation home for portions of the year. However, the house became your primary residence two years before the sale. In that case, you would be eligible for the exclusion up to the limit or the total amount of the gain, whichever is less.
Renting the home for profit will reduce the allowable exclusion.
Suppose you owned the home for the previous five years and lived in it for two but rented the house to others for three of the five years. In that case, you can only exclude two-fifths of the gain. For example:
- The taxpayer's basis in the home is $400,000, and he has owned it for five years.
- The current value is $900,000, a gain of $500,000.
- The taxpayer lived in the home for two years and rented it to others at market value for three years.
- The exclusion is limited to the two years when the property was not being used as a business. So, $200,000 is the maximum exclusion. However, the exclusion could encompass the entire gain if the home was not rented out but instead used as a vacation home.
This exclusion is only available once every two years. So, for example, if the taxpayer owns two homes and has rotated residency with two years in one followed by two years in the next, still owning both, the taxpayer can sell both houses at the same time but is only allowed one exclusion. Furthermore, if the home is a vacation home that the taxpayer resides in for a portion of each year, but the occupancy in the house doesn't equal two years, the taxpayer won't be allowed the exclusion.
How do I report the exclusion?
When you sell property such as your residence, the entity who closed the transaction must file the 1099-S Form. Often this responsibility belongs to the title company, attorney, or realtor. The taxpayer uses Form 8949 to reconcile the information and transfer it to Schedule D of the 1040 form.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.