Under IRC §121, gain on the sale of a principal residence of up to $250,000 (or $500,000 for spouses, see below) may be excluded from gross income. This may seem pretty straightforward, and many times it is, but it also has numerous requirements in order to apply, as well as numerous exceptions that may apply.
To start, it helps to understand what constitutes gross income. Under §61, gross income “means all income from whatever source derived” including but not limited to a list of fourteen items, one of which is “Gains derived from dealings in property”. This all-encompassing definition of gross income includes gain on the sale of personal property including cars, boats, collectible items, vacation homes, and of note for this article, your personal residence.
On the flip side, there is no entitlement to a deduction or an exclusion from gross income, but “every deduction is a matter of legislative grace.”[1]Fortunately for folks selling their principal residences, Congress has offered them such “legislative grace” in the form of §121.
What is a Principal Residence?
The taxpayer’s principal residence is determined on a case-by-case basis on the particular facts and circumstances, and this may be a houseboat, a house-trailer, or even a house or apartment occupied by the taxpayer under a cooperative housing corporation agreement.[2] In most cases, this is probably straightforward. However, where the taxpayer has multiple residences, it may be more complex. If a taxpayer alternates between multiple properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer’s principal residence.[3] The Regulations go on to list a handful of factors that are to be considered in making the determination.
What Are the Ownership and Use Requirements?
Assuming the property is the taxpayer’s principal residence, the taxpayer must have owned and used the property as their principal residence during at least two of the last five years ending on the date of the sale.[4] The determination of time used is in the aggregate, meaning the two years of ownership and use does not have to be concurrent, it just has to equate to two years in total during the five year period.
How Much Gain Can Be Excluded?
The exclusion amount is up to $250,000 of gain.[5] However, for married couples filing a joint return, that amount is bumped up to $500,000 if: (i) either spouse meets the ownership requirements with respect to such property; (ii) both spouses meet the use requirements with respect to such property; and (iii) neither spouse is ineligible for the benefits with respect to such property by reason of paragraph (3) (discussed below).[6] Paragraph (3) referenced in the prior sentence states that taxpayers can only take advantage of the gain exclusion under §121 once every two years. Note also that exclusion amount is up to $500,000 still applies in the case of a widow or widower as long as the sale takes place within two years of the date of death of the deceased spouse and all the requirements discussed above were met immediately prior to the death.[7]
What About the Exceptions and/or Special Rules?
As noted in the introductory paragraph, there are numerous exceptions and special rules to watch out for, including but not limited to the following:
- The gain exclusion only applies to one sale every two years.[8]
- The gain exclusion does not apply to gain allocated to periods of non-qualified use, and in such cases, the taxpayer must determine such gain allocated to periods of non-qualified use based on the amount of time of such non-qualified use over the time the taxpayer owned the property.[9] Fortunately, the “period of non-qualified use” does not include any portion of the five year period from §121(a) which is after the last date that such property is sued as the principal residence of the taxpayer or the taxpayer’s spouse.[10]
- If the sale of the home is due to change in place of employment, health, or unforeseen circumstances, the taxpayer may still qualify for partial exclusion even if they do not meet the ownership and use requirements under §121(a).[11] In such a case, the exclusion amount available is pro-rated. The regulations go into significant detail as to what is required to meet the requirements for this to apply, including a distance safe harbor if the new place of employment is located at least fifty miles from the former place of employment.[12]
- Involuntary conversions are treated as a sale or exchange for purposes of §121.[13]
- Depreciation recapture is not excluded.[14]
- There’s a special rule for a taxpayer who requires out of residence care, and in such cases, as long as the taxpayer owned and used the property during one year of the five year period under §121(a), then the taxpayer is considered to have used the property as his or her personal residence during the time period they owned the property and resided at a state licensed facility such as a nursing home.[15]
- There are special rules for military personnel, the intelligence community, and those involved in foreign service.[16]
- 121 does not apply to property acquired in a like-kind exchange in which gain was not recognized under §1031(a) or (b), though a transaction may be structure to take advantage of both §121 and §1031, often in the case of vacant land which adjoins a personal residence being involved.[17]
- The gain exclusion does not apply to property held in a trust, unless such trust is treated a grantor trust and owned by the taxpayer under §§671-679.[18] A grantor trust is a trust of which the IRS considers the grantor (or the beneficiary in case of a §678 trust) as the owner of the assets held in trust but only for federal income tax purposes. A standard revocable or living trust that is used for estate planning purposes, often to avoid probate, is a grantor trust and thus still allows the taxpayer to qualify for §121 even though their residence is owned in the trust.
Conclusion
In many cases, the application of §121 is pretty straightforward. If you owned and lived in a home for the last two years, and you sell it, you qualify. However, life is not always that simple and we often get complex fact patterns presented to us. As you can see by some of the exceptions and special rules, the application of §121 can be tricky when applying it to such complex fact patterns. Taxpayers are encouraged to dot their “I’s” and cross their “T’s” and seek competent tax advice when it comes to making sure they are availing themselves of the §121 gain exclusion.
[1] White v. US, 305 US 281 (1938).
[2] Treas. Reg. §1.121-1(b)(1).
[3] Treas. Reg. §1.121-1(b)(2).
[4] §121(a).
[5] §121(b)(1).
[6] §121(b)(2)(A).
[7] §121(b)(4).
[8] §121(b)(3).
[9] §121(b)(5).
[10] §121(b)(5)(C).
[11] §121(c).
[12] Treas. Reg. §1.121-3.
[13] §121(d)(5).
[14] §121(d)(6).
[15] §121(d)(7).
[16] §121(d)(8).
[17] §121(d)(10).
[18] Treas. Reg. §1.121-1(c)(3)(i).
