I don’t think I’m breaking any news when I say that you’ve always been a disappointment to your Dad. It all started when he proudly showed up to your fifth grade field day — so full of hope and pride — only to watch you jog a quarter-mile, vomit all over your shoes, and spend the next two hours crying under a tree. Ever since then, he’s more or less left you alone.
Well, it turns out Dad wasn’t all that perfect either, was he? A few years ago, his email address was all over the Ashley Madison hack, so now he’s stuck living at the local La Quinta while Mom and her divorce attorney dish out a financial depantsing. With Dad down on his luck, he’s desperate enough to turn to even you for help: the divorce decree allows Mom to stay in the house for a few years before it’s required to be sold and the proceeds split, and your ol’ man wants you to tell him if he’ll have to suffer the ultimate indignity of being handed a tax bill upon the sale of the home his ex-wife is living in with her 26-year old HIIT instructor.
Can you do it? Truthfully, without some help, you’d probably let him down again, just as you did on that sad, sad field day many moons ago. But don’t worry, I’ve got you covered, and together we’ll win back your father’s respect, which will come in handy since he’ll soon be your roommate. Read on, and I’ll give you everything you need to know about when the sale of a home is tax-free.
Section 121, In General
Congress has long encouraged home ownership through the Internal Revenue Code, whether through deductions for mortgage interest or real estate taxes or the exclusion of gain upon the sale of a principal residence. Prior to 1997, the exclusion upon sale came as two options: the first in the form of a “rollover;” if you sold your home and reinvested the proceeds into a new one, you were permitted to defer the gain on the sale by carrying over the basis of the old home into its replacement. Alternatively, if you were 55 or older at the time of sale, you could take advantage of a “one-time only” permanent exclusion of up to $125,000 of gain.
In 1997, Congress dropped the rollover provision, and in exchange, greatly enhanced the exclusion rules. As a result, for the past 22 years, Section 121 has allowed homeowners of any age to exclude gain on the sale of a “principal residence” provided three tests are met:
- You owned the home for two of the five years preceding the sale (the “ownership test),”
- You used the home for two of the five years preceding the sale (the “use test”), and
- You haven’t taken advantage of the Section 121 exclusion in the two years preceding the sale (the “once-every-two-years rule”).
The maximum exclusion, as a general rule, can’t exceed $250,000. In its most basic form, the exclusion works like so:
Ex. A, a single taxpayer, purchased a home as his principle residence for $320,000 on June 3, 2013. He resided in the house the entire time, and spent $20,000 improving the home. On July 15, 2019, A sold the home for $430,000, recognizing $90,000 gain. Because A owned and used the home as his principle residence for at least two of the five years prior to July 15, 2019, A may exclude up to $250,000 of gain; thus, A may exclude the entire gain.
Seems simple enough, no? Well, like all things in the Code, there are far more traps for the unwary — and hidden opportunities — than are readily apparent at first blush. And while you may not work in Section 121 on a regular basis in your practice, this is what I refer to as a “hero provision;” get to know Section 121 well, and you may be able to save your parents, your siblings, your friends, and even yourself — tens of thousands of dollars in tax.
So why don’t we take a look at some of these special rules that may make the difference between getting an exclusion or paying a hefty tax bill. The way I see it, there are 12 rules we’ve got to cover, but before we can get started, we have to address a rather important issue: what makes a home your “principal residence?”
Principal Residence, In General
First things first: a “residence” may include a houseboat, or a house trailer. More important to the Section 121 exclusion, however, is that your residence must qualify as your “principal” residence. As a rule, you can only have one principal residence each year, and if you alternate your time between two residences, it is generally the home that you use the majority of the year that will be treated as your principal residence. There are other factors taken into consideration, however, including:
- your place of employment,
- the principal place of abode of your family members,
- the address listed on your federal and state tax returns, driver’s license, auto registration, and voter registration card,
- your mailing address for bills and correspondence,
- the location of your banks, and
- the location of religious organizations and recreational clubs with which you are affiliated.
While Section 121 appears to only require that you own and use a home for 24 months out of the five years preceding its sale to benefit from the exclusion, that is not the best way to look at it. It is critical to remember that you have to own and use that property as your principal residence for two of the five years. Let’s look at how you could go astray:
Ex. A splits time between New York and Florida. From 2015 through 2019, A spends the following number of months in each of his two homes:
New York Florida 2015 7 5 2016 7 5 2017 7 5 2018 7 5 2019 7 5 total 35 25
On January 1, 2020, A sells the Florida home for a large gain. May A use Section 121? A has used the home for 25 months in the preceding five years; this is more than two years. But was the Florida home ever his principal residence? Based strictly on the number of months spent in each home, the answer is no, the New York home was always the principal residence. As a result, A never used the Florida home as his principal residence, and thus fails the two-year use test unless the other facts and circumstances discussed above were able to convince the IRS that the Florida home was, in fact, his principal residence.
Of course, the math is such that you can have TWO principal residences at the same time. Assume the following usage by A:
New York Florida 2015 7 5 2016 5 7 2017 7 5 2017 5 7 2018 7 5 Total 31 29
In this situation, A used the New York home and the Florida home for more than 24 months in the preceding five years. More importantly, he used the New York home as his principal residence for three of the five years, and the Florida home as his principal residence for two of the five years. Thus, if A were to sell EITHER home on January 1, 2020, he could use the Section 121 exclusion. Note, however, that he can’t sell BOTH, because you are limited to one Section 121 exclusion every two years.
OK, now that we know how to identify your principal residence, let’s get into some of the more nuanced rules that may catch you off guard.
Rule #1: You don’t have to meet the ownership and use test at the same time
Ex. 1. A, a single mother, rents a home as her principle residence from January 1, 2015 through December 31, 2017. On January 1, 2018, A moves away, but she wants her college-aged daughter to have a home to live in while she finishes school, so she buys the house they previously rented, and her daughter lives there for all of 2018 and 2019. On January 1, 2020, A sells the house for a large gain. Does A pass the ownership and use test?
Take a look at Reg. Section 1.121-1(c)(1), which provides that “the requirements of ownership and use for periods aggregating 2 years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 x 2). The requirements of ownership and use may be satisfied during nonconcurrent periods if both the ownership and use tests are met during the 5-year period ending on the date of the sale or exchange.”
Ex. 1. A sold her home on January 1, 2020. In the five years preceding the sale, A USED the home as her principle residence for three years (January 1, 2015 through December 31, 2017) and OWNED the home for two years (2018 and 2019). The fact that A didn’t use and own the home at the same time does not matter; she passes both tests.
Rule #2: Temporary or seasonal absences don’t count against the use test.
Ex. 2. A purchased a home on January 1, 2016 for use as a principle residence. During 2016 and 2017, A spent two months each summer teaching abroad. On January 1, 2018, A sold the home. Does A satisfy the use test?
Reg. Section 1.121-1(c)(2)(i) provides, “in establishing whether a taxpayer has satisfied the 2-year use requirement, occupancy of the residence is required. However, short temporary absences, such as for vacation or other seasonal absence (although accompanied with rental of the residence), are counted as periods of use.”
Ex. 2. Even though A spent only 20 of the 24 months in 2016 and 2017 in his home, the four months A spent teaching abroad do not count against the use test, as they represent short temporary absences. Thus, A passes the use test.
Rule #3: If the requirements are met, a married couple that files jointly can exclude up to $500,000 of gain
Ex. 3. H purchased a home on January 1, 2015. On January 1, 2018, H and W marry, and W moves in the home, but the home remains owned by H only. On January 1, 2020, H&W sell the home. What is the maximum Section 121 exclusion H&W are entitled to?
Pursuant to Reg. Section 1.121-2(a)(3)(i), a married couple that files a joint return can exclude up to $500,000 of gain provided:
- one of the spouses satisfies the ownership test,
- BOTH of the spouses satisfy the use test, and
- Neither spouse has used Section 121 in the past two years.
The reason for this rule is obvious: Congress anticipated that when a couple marries, one spouse may already own a home, and in many cases, the home isn’t re-titled into joint ownership. Thus, only one spouse needs to own the property, though both must pass the use test.
Ex. 3. In our example, H owned the home from 2015-2020. H&W used the home for two of the five years preceding the sale (2018 and 2019. Neither spouse used Section 121 in 2018 or 2019. As a result, upon the sale of the home on January 1, 2020, H&W may exclude up to $500,000 of gain.
Rule #4: What if both spouses DON’T meet the tests in Rule 3?
Ex. 4. H purchased a home on January 1, 2015. On January 1, 2019, H and W marry, and W moves in the home, but the home remains owned by H only. On January 1, 2020, H&W sell the home. What is the maximum Section 121 exclusion H&W are entitled to?
Reg. Section 1.121-2(a)(3)(ii) offers the following rule: “for taxpayers filing jointly, if either spouse fails to meet the requirements of paragraph of this section, the maximum limitation amount to be claimed by the couple is the sum of each spouse’s limitation amount determined on a separate basis as if they had not been married. For this purpose, each spouse is treated as owning the property during the period that either spouse owned the property.
Ex. 4. In this case, while H owned the home for five years prior to its sale, H and W did not BOTH use the home for two of the preceding five years, because W only used the home in in 2019. As a result, H and W must determine their separate limitations. H has a limitation of $250,000 because H met all tests. W has a limitation of $0 because she did not meet the use test. Thus, the total limitation is $250,000. (Note, however, that if the sale of the home was caused by a change in health, employment, or unforeseen circumstances of either H or W, W might be entitled to a $125,000 exclusion. See the discussion in Rule #12 below).
Rule #5: Married couples that sell separately owned homes may each exclude up to $250,000 of gain if all tests are met. But that’s different than saying a TOTAL exclusion of $500,000.
Ex. 5. During 2019, married Taxpayers H and W each sell a residence that each had separately owned and used as a principal residence before their marriage. Each spouse meets the ownership and use tests for his or her respective residence. H and W file a joint return for the year of the sales. The gain realized from the sale of H’s residence is $200,000. The gain realized from the sale of W’s residence is $300,000.
Reg. Section 1.121-2(a)(1) provides a very simple rule, but one that taxpayers often run afoul of: “a taxpayer may exclude from gross income up to $250,000 of gain from the sale or exchange of the taxpayer’s principal residence.”
Ex. 5. H and W must measure their satisfaction of the ownership and use test separately with regard to each residence. H and W both pass the tests, so each may exclude up to $250,000 of gain. But notice: H has only $200,000 of gain, while W has $300,000 of gain. Because they don’t get a MAXIMUM exclusion of $500,000 in this situation — rather, they EACH get a maximum exclusion of $250,000 — W can’t avail herself of H’s excess exclusion. Thus, H excludes $200,000, and W excludes $250,000.
Rule #6: When one spouse dies, the other can count the period of time the deceased owned and used the home.
Ex. 6. H has owned and used a house as his principal residence since January 1, 2015. On January 1, 2018, W married H and moved into the house, but the house remained in H’s name only. H died on December 31, 2018. After H’s death, the home passes to W. In 2019, W sells the home. Is W entitled to Section 121?
Time to turn to the statute. Section 121(d)(2) offers a benefit to the surviving spouse, providing that, “in the case of an unmarried individual whose spouse is deceased on the date of the sale or exchange of property, the period such unmarried individual owned and used such property shall include the period such deceased spouse owned and used such property before death.
Ex. 6. When W sells the house in 2019, she has not owned or used the home for two of the preceding years when measured on her own. She never owned it until 2019, and only used it during 2018 and part of 2019. Nevertheless, the statue allows W to include in her ownership and use tests the period of time H owned and and used the home as his principal residence. As a result, W is treated as owning the home from 2015 through 2019 and using it for that same period. She satisfies both tests.
Rule #7: But how much gain can the surviving spouse in Rule #6 exclude?
Ex. 7. H has owned and used a house as his principal residence since January 1, 2015. On January 1, 2016, W married H and moved into the house. H died on December 31, 2018. After H’s death, the home passed to W. On June 7, 2020, W sells the home. What is W’s maximum Section 121 exclusion?
Section 121(b)(4) gives relief to a surviving spouse, allowing for time to sell a house and still enjoy a maximum exclusion of $500,000. It provides, ” in the case of a sale or exchange of property by an unmarried individual whose spouse is deceased on the date of such sale, paragraph (1) shall be applied by substituting “$500,000” for “$250,000” if such sale occurs not later than 2 years after the date of death of such spouse and the requirements of Rule #3 above were met immediately before such date of death.
Ex. 7. On the date of H’s death, if the house had been sold on that date, H&W would have been entitled to a $500,000 exclusion, because: 1) H owned the house from 2015-2019, and, 2) H&W both satisfied the use test. As a result, as long as the house was sold within two years of the date of death (December 31, 2018) — and it was — W may exclude up to $500,000 of gain despite the fact that she is ineligible to file a joint return for that year.
Rule #8: Treatment of spouse receiving house incident to divorce
Ex. 8. H buys a home on January 1, 2015. On January 1, 2018, W marries H and moves in the home, but the home remains in H’s name only. On January 1, 2019, H&W get divorced and H transfers ownership of the house to W in a tax-free Section 1041 transfer (a transfer of property incident to a divorce). On January 1, 2020, W sells the home. Is she entitled to the Section 121 exclusion?
Reg. Section 1.121-4(b)(1) has you covered, providing, “if a taxpayer obtains property from a spouse or former spouse in a transaction described in Section 1041(a), the period that the taxpayer owns the property will include the period that the spouse or former spouse owned the property.
Ex. 8. W only owned the home from January 1, 2019 through January 1, 2020. The regulations, however, treat W as having also owned the home during the time it was owned by H — January 1, 2015 – January 1, 2019. As a result, W satisfies the ownership and use test and is entitled to a $250,000 exclusion upon sale.
Rule #9: Treatment of spouse transferring use of house incident to divorce
Ex. 9. H buys a home to be used as his principle residence n January 1, 2015. On January 1, 2018, W marries H and moves in the home. On January 1, 2019, H&W get divorced. H remains the owner of the home, but W is entitled to use the home, and upon a sale, H&W will split the gain and proceeds evenly. W uses the home for 2019-2022, and then sells the home on January 1, 2023. Is H entitled to the Section 121 exclusion?
Let’s take a look at Reg. Section 1.121-4(b)(2): A taxpayer is treated as using property as the taxpayer’s principal residence for any period that the taxpayer has an ownership interest in the property and the taxpayer’s spouse or former spouse is granted use of the property under a divorce or separation instrument (as defined in Section 71(b)(2)), provided that the spouse or former spouse uses the property as his or her principal residence.
Ex. 9. Hey look, help for your ol’ man! H did not use the property for two of the five years preceding the sale (he only used it for 2018, while W used it from 2019-2023) H, however, is treated as using the house during the period W used the property because 1) H allowed W to use the house incident to their divorce, and 2) W used the house as her personal residence during that time. Thus, H satisfies the ownership test (2015-2023) and the use test (2015-2023) and is entitled to a $250,000 exclusion.
Rule #10: Treatment of sale of home that was previously rented to tenants or used as a home office
Ex. 10. A bought a home on January 1, 2015 for $300,000 and rented it to a tenant until December 31, 2016. A claimed $10,000 of depreciation during that time. A then used the home as a principal residence from January 1, 2016 through January 1, 2020, when it was sold for $400,000, giving rise to a gain of $110,000. What is A’s maximum Section 121 exclusion?
Here, we’ve got two different rules we have to address. First, Section 121(d)(6) states that the Section 121 exclusion “shall not apply to so much of the gain from the sale of any property as does not exceed the portion of the depreciation adjustments attributable to periods after May 6, 1997, in respect of such property.” In other words, any prior depreciation is “pulled out” of the gain eligible for exclusion and must be recognized as unrecaptured Section 1250 gain.
Then, we have to address Section 121(b)(5), which provides that the Section 121 exclusion “shall not apply to so much of the gain from the sale or exchange of property as is allocated to periods of nonqualified use.” So what is “nonqualified use?” It’s any period after 2008 during which the home is NOT used as a principal residence. If you have a period of nonqualified use, you have to allocate the gain on the sale of the property between qualified and nonqualified use via the following formula:
period of nonqualified use after 2009/total period of time the home was owned * total gain
For these purposes, the gain does NOT include the depreciation that was previously recaptured.
Ex. 10. Putting it all together, in our example, step 1 is to pull out the $10,000 of depreciation previously claimed by A and recognizing that as gain upon sale. We have $100,000 of gain remaining. We also, unfortunately, have a two-year period of nonqualified use — 2015 and 2016 — during the five-year period A owned the house. As a result, A must allocate 2/5 of the gain, or $40,000, to nonqualified use. Thus, the maximum amount of gain A max exclude under Section 121 is $60,000.
Rule #11: Rule when non-qualified use comes AFTER last use as a principal residence
Ex. 11. A owned a home and used it as a personal residence from January 1, 2015 through December 31, 2018. A then rented the home in 2019 and 2020 (claiming depreciation deductions of $10,000), and sold the home on January 1, 2021 for a gain of $100,000. How much gain may A exclude?
We’ve already established that we have to pick up the $10,000 of prior depreciation as unrecaptured Section 1250 gain. And as in the previous example, we have a period of nonqualified use, so we’ll have to allocate the remaining $90,000 of gain between eligible and ineligible for Section 121, correct?
Incorrect. Section 121(b)(5)(C)(ii) provides that nonqualified use does NOT include any period where the property was not used as a principal residence that came AFTER the last date the home was used a principal residence by the taxpayer or the taxpayer’s spouse. Why? Because Congress recognizes that sometimes we’re forced to move quickly, and may not be able to sell our home as expeditiously as we would like, so we rent it out. This period of rental will NOT count as nonqualified use and reduce our gain eligible for the Section 121 exclusion.
Ex. 11. Because A’s rental period (2019 and 2020) came AFTER the last date the home was used by A as his principal residence, the period is not considered a period of nonqualified use, and no allocation of the gain is necessary.
Rule #12: Reduced maximum exclusion for taxpayers failing to meet certain requirements
Ex. 12. A purchased a home in Colorado as his principal residence on January 1, 2018. On January 1, 2019, his employer transferred him to New Jersey, and he was forced to sell his home. On June 30, 2019, the home was sold. May A exclude any of the gain?
Tip: if you ever have to sell your principal residence before you intended because 1. you got sick, 2. you switched jobs, or 3. some other unforeseen result arose, flip to Reg. Section 1.121-3. In paragraph (b), it explains that a reduced exclusion is available to someone who sells their principal residence by reason of a change in health, place of employment, or unforeseen circumstances. The regulations go on to provide a few safe harbors, before stating that if you fail to meet a safe harbor, you can only take the position that the sale was due to health, change of employment or unforeseen circumstances if that was the primary reason for the sale. Some of the factors to consider if you fail to meet a safe harbor are:
- Did the sale or exchange and the circumstances giving rise to the sale occur close together in time?
- Did the suitability of the property as your principal residence materially change because of the circumstances?
- Were the circumstances giving rise to the forced sale reasonably foreseeable at the time you began using the property as your principal residence?
As mentioned, there are safe harbors that can be satisfied. For example, if you take a new job that is more than 50 miles farther from your residence than your old job, then your sale is due to a change in employment. The same holds true if you had no previous job, but your first job is more than 50 miles from your old residence.
A safe harbor can be satisfied that a sale is due to health if a physician recommends a change of residence for reasons of health.
Finally, certain occurrences will be treated as “unforeseen circumstances” giving rise to a necessary sale, and thus a reduced exclusion:
- Involuntary conversion of the residence,
- Natural or man-made disasters or acts of war or terrorism,
- Multiple births from the same pregnancy (worse than death),
- A change in employment that results in your inability to pay basic living expenses and housing costs.
Beyond those safe harbors, you can still take the position that your sale was forced by unforeseen consequences, and the IRS has been fairly liberal in allowing a reduced exclusion. Don’t believe me? Check this out.
The change in health, employment, or unforeseen circumstances do not have to be inflicted upon the home owner; rather, if any “qualified individual” has the aforementioned change, the owner of the home is eligible for the reduced exclusion. A qualified individual includes the taxpayer (obviously), the taxpayer’s spouse, any co-owner of the residence, any person who’s principal place of abode is in the same household as the taxpayer, and any person who would qualify as a dependent of any of the previously listed qualified taxpayers.
If the requirements are met, you may claim a reduced Section 121 exclusion by multiplying $250,000 (or $500,000 in the case of a qualifying joint return by a fraction, the numerator of which is the shortest period of 1) ownership, 2) use, or 3) the period of time since the last Section 121 sale, and the denominator of which is 24 months.
Ex. 12. In our example, A’s sale was forced by his transfer from Colorado to New Jersey after only one year in the home. This satisfies the change of employment safe harbor, and thus A is entitled to a reduced exclusion computed by multiplying $250,000 by a fraction, the numerator of which is 12 (the number of months the home was owned and used by A), and the denominator of which is 24. Thus, A is entitled to a $125,000 exclusion.
There you have it…everything you need to know about Section 121 and the home sale exclusion. The good news? Courtesy of Rule # 9, you can now inform Dad that he’ll be able to avoid a tax bill when he sells the house Mom’s been living in for years after the divorce. The bad news? When you provide him with that advice, it will remind him that you grew up to be an accountant rather than the race car driver he’d hoped for, and his great sense of shame will only grow.