An individual homeowner does not have to pay capital gains taxes on the proceeds from the sale of his personal residence if his capital gain is less than $250,000 (so long as certain conditions are met). A married couple filing jointly can shelter the proceeds from the sale of their home from capital gains taxes if their gain is less than $500,000. Note that these limitations concern the gain and not the total proceeds from the sale. Roughly speaking, if a home’s basis is $100,000 and it sells for $600,000, the capital gain is only $500,000. This tax shelter is called the “Home Sale Exclusion” and is detailed in Internal Revenue Code (IRC) section 121.
A 121 exclusion is quite different from a 1031 exchange. In a 1031 exchange, the taxpayer cannot take constructive receipt of the proceeds from the sale of the relinquished property. The capital is held by a qualified intermediary and then reinvested into a like-kind property, thereby deferring the realization—and taxation—of any gain. In a 121 exclusion, however, the homeowner does receive the proceeds from the sale of his personal residence, yet he does not need to pay taxes on any capital gains (up to a certain amount). While a 1031 exchange defers capital gains taxes, a 121 exclusion shelters capital gains from being taxed altogether. There is no limit to the total number of times a taxpayer can take the Home Sale Exclusion, so long as the requirements are met. Here are the guidelines that you need to know to use the Section 121 Home Sale exclusion.
Ownership and Use Requirements
The Home May Be a House, Apartment, Condominium, Mobile Home, Houseboat, or Tenant Stock
The purpose of the Home Sale Exclusion is to exclude gain realized on the sale of a taxpayer’s home from his gross income. The home does not have to be a house or even a single-family dwelling. It may be a duplex, condo, mobile home (if permanently fixed to the land), an apartment, or even stock held by a tenant in a housing co-operative. Personal property that is not a “fixture” under local law does not qualify. Vacant land by itself does not qualify, but vacant land that is part of or adjacent to a taxpayer’s principal dwelling may qualify. If the land is sold separately, the maximum amount of gain that may be sheltered applies to the combined gains from the sale of the vacant land and the dwelling.
The Home Must Be Owned for a Total of at Least Two Years During the Five-Year Period Leading Up to the Sale
In order to legally shelter the proceeds received from the sale of one’s home, a taxpayer must own the home for an aggregate of two years prior to the sale. This ownership does not have to be continuous; it may be broken up or interrupted, so long as the total duration of ownership adds up to at least two years and occurs within the five-year period leading up to the sale of the home.
The Home Must Be Used as the Taxpayer’s Principal Residence for a Total of at Least Two Years During the Five-Year Period Leading Up to the Sale
In addition to the ownership requirement, to shelter gain from the sale of a home from taxable recognition, the home must also be used as the taxpayer’s principal residence for an aggregate of two years during the five-year period leading up to the sale of the home. This use does not have to be continuous; it may be broken up, so long as the total duration of use adds up to at least two years and occurs within the five-year period leading up to the sale of the home. Additionally, short vacations and seasonal absences may be included in the use period, even if the residence is rented out during these absences.Determining the “principal” residence of a taxpayer involves consideration of several factors, including where the taxpayer works, where the taxpayer’s family lives, the taxpayer’s mailing and billing addresses, the location of the taxpayer’s banks, and the location of the taxpayer’s religious and recreational activities. This also means that the Home Sale Exclusion cannot be taken on more than one home at a time.
There are a few exceptions to the use requirement for out-of-residence care, unforeseen circumstances, and uniformed, military, and intelligence service.
The Periods of Ownership and Use of the Home Do Not Have to Coincide
The requirements for ownership and use of the home may be satisfied during non-concurrent periods so long as both of the requirements are met during the five-year period leading up to the sale. This may be helpful for a tenant who rents a home prior to buying it.
Requirements for Married Couples Filing Jointly
A married couple filing jointly may exclude from their gross income up to $500,000 of capital gain from the sale of their principal residence. Here are the details.
EITHER Spouse May Meet the Ownership Requirement
For a married couple to legally shelter gain from the sale of their home utilizing the Home Sale Exclusion, it is necessary for only one of the spouses to meet the ownership requirements of IRC section 121 discussed above.
BOTH Spouses Must Meet the Use Requirement
Although either spouse may own the home, both spouses must use the home together as their principal residence to shelter the gain from taxable recognition.
NEITHER Spouse May Exclude Gain from Another HomeOnly a taxpayer’s principal residence qualifies for the Home Sale Exclusion, which means that the exclusion may be taken on only one home at a time. This holds true whether the taxpayer is an individual or a married couple filing jointly.
If the Above Requirements Are Not All Satisfied…
If all of the above requirements are not met, the total amount of gain that may be excluded from taxable recognition is calculated for each spouse individually, up to $250,000 each. Even in this case, it is necessary for only one of the spouses to meet the ownership requirements.
If a Taxpayer’s Spouse Dies…
If the spouse of a taxpayer is deceased at the time of the sale of the home, the surviving taxpayer may exclude up to $500,000 of gain if the ownership and use requirements are met and the sale occurs within two years after the death of the spouse.
The IRC section 121 Home Sale Exclusion can be a significant tax shelter for capital gain if the legal requirements are met. There are many nuances, and this article is not offered as tax or legal advice. If you have recently sold your home or are considering whether to sell your home, we can refer you to a tax professional who can help.