What is a Section 121 Exclusion?

Posted Dec 29, 2022


One of the motivators for buying real estate is that it tends to appreciate. Of course, this result isn't guaranteed, and there are notable periods when real estate values have dropped. However, buying real estate is a good bet over time, and you may earn significant increases in value. This potential outcome applies to both investment property and personal use assets.

In fact, for many people, their most valuable asset is their residence. Buying a home is a widely sought milestone that represents success. If you sell your home after it has increased in value, that is a capital gain, and such gains are subject to the capital gains tax, either short-term or long-term.

Capital gains exclusions have evolved.

Congress passed the first carve-out for taxing the gain from selling a primary residence in 1951. The relevant code section was designated 112, allowing taxpayers to defer the gain from selling their home if they purchased a new home of at least the same value. Because the gain was deferred and not eliminated, taxpayers were supposed to track their accumulated gains history until executing a final sale.

Section 112 was redesignated Section 1034 and was augmented by Section 121 in 1964. The initial version of Section 121 allowed a one-time exclusion of up to $125,000 in capital gains for taxpayers over 55 if they met the eligibility requirements. To qualify for the exclusion, the taxpayer must have lived in the home for at least three of the five years preceding the sale. In addition, if the gain was less than $125,000, the taxpayer could not use up the balance with a later deal.

In 1997 Congress repealed Section 1034 and updated Section 121 by removing the age requirement and the single-use provision. In addition, the new update increased the maximum exclusion to $250,000 ($500,000 for married couples filing taxes jointly) and reduced the residency test to require occupancy for at least two of the preceding five years.

Section 121 has some wiggle room.

Section 121 requires that the taxpayer own and reside in the property for two of the preceding five years. However, the use and ownership do not have to be concurrent or consecutive. For example, suppose you own a home you purchased ten years ago. Perhaps you originally lived in the property, then five years ago, you leased it to someone else, and you moved back in two years ago. This timeline would qualify you for the exclusion.

However, it is also possible that the taxpayer lived in the home as a rental starting five years ago and, after two years, bought the property and then rented it to someone else. In this case, the periods of ownership and occupancy are not the same, but the taxpayer meets the requirements regardless. On the other hand, if the taxpayer has sold a different home for which they met the criteria during the last two years, they may not obtain a second exclusion.

Further, suppose that one spouse owned and lived in the home, but the other did not. The two spouses filing jointly are still eligible for the married couple exclusion limit of $500,000.

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. 

Hypothetical examples shown are for illustrative purposes only.

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