Selling your home could come with a significant tax advantage. In this article, Senior Accountant Atira Boos, CPA outlines the requirements and planning considerations taxpayers should understand before finalizing a sale.
If a taxpayer sells their principal residence at a gain, they may be eligible to exclude part of that gain from taxable income under IRC Section 121. This exclusion allows up to $250,000 for single filers or up to $500,000 for married couples filing jointly. However, the exclusion may only be claimed once every two years. To qualify, certain ownership and use requirements must be met, and there are additional factors to consider, as outlined below.
Requirements for the exclusion:
Principal Residence
In order to qualify for the gain exclusion, the home must be considered the taxpayer’s principal residence and must have been owned and used for specific periods, discussed in the next section, by the taxpayer.
For a dwelling unit to be considered a principal residence, it must meet the criteria for ownership and use as the taxpayer’s main home. A dwelling unit generally refers to property used for living purposes, such as a house, condominium, apartment, mobile home, or similar structure. The principal residence typically includes the dwelling unit along with at least a portion of the land on which it is located. If the taxpayer has multiple properties, the principal residence will be the property that was used majority of the time during the year.
Some items to consider when determining if a property is a taxpayer’s principal residence include: the taxpayer’s place of employment; the address listed on the taxpayer’s Federal and State tax returns; the taxpayer’s mailing address; and the location of the taxpayer’s banks.
If a taxpayer owns vacant land that is separate from the dwelling unit, the gain from its sale may qualify for exclusion under certain conditions. Generally, vacant land is not considered part of a principal residence unless it is adjacent to the property containing the taxpayer’s home and used as part of that principal residence (for example, as part of the yard, driveway, or recreational area).
To qualify for the Section 121 exclusion, the vacant land and the principal residence must be sold within two years of each other, either before or after the home sale. If the land is sold more than two years before or after the sale of the principal residence, the gain on that land is fully taxable and does not qualify for any exclusion.
Ownership and Use
In order to qualify for the gain exclusion, the principal residence must have been owned and used for 2 or more years during a 5-year period ending on the date of sale. The taxpayer must have occupied the home, with an exception to vacations or other temporary absences, for a full 24 months within the 5-year period. When filing jointly with a spouse, up to $500,000 of the gain can be excluded if either or both spouses meet the 2-year ownership requirement.
Surviving spouses can exclude up to $500,000 of the gain if they sell the home within 2 years of their spouses’ death and the two-out-of-five-year ownership requirement was met immediately before the date of death.
The exclusion may also apply in the case of a divorce. If the residence is sold together, then an exclusion will apply as long as the ownership and use requirements were met. In the case of a spouse buying the property from the other spouse, the gain can still be excluded as long as the selling spouse met the 2-out-of-5-year ownership requirement.
There is an exception to the standard five-year ownership and use test that allows qualifying taxpayers to extend the period to ten years. This exception applies to members of the uniformed services, Foreign Service, the intelligence community, and the Peace Corps. Under this provision, the five-year test period may be suspended during any time the taxpayer (or their spouse) is on qualified official extended duty. A taxpayer is considered to be on qualified official extended duty if they are stationed at least 50 miles from their principal residence or are residing under government orders in government housing for a period exceeding 90 days.
To elect this suspension, the taxpayer will claim the exclusion on their income tax return for the year of sale and will not include the gain from the sale as income. The election is made by taking the position on the return, a separate statement or formal election form is not required. However, the taxpayer should retain documentation supporting the qualified extended duty (such as official orders or proof of service) in their records in case of IRS inquiry. This election is only available once and cannot be applied to any other primary residence in the future
Additional considerations:
Partial Business Use of a Principal Residence
When a portion of the principal residence is used for business, the gain exclusion under Section 121 may be limited. The limitation depends on whether the business use is part of the taxpayer’s dwelling unit or located in a separate structure. If the business portion is located in a separate structure, such as a detached garage or workshop, the gain must be allocated between the residential portion (which may qualify for the exclusion) and the business portion (which does not). For example: A taxpayer owns a house, surrounding land, and a separate garage used exclusively for business. Because the garage is separate from the dwelling unit, the gain must be allocated between the residence and the garage.
However, if the business use is within the same dwelling unit, such as a home office, no allocation of gain is required. The taxpayer may generally exclude the entire gain under Section 121, except for any portion of the gain that is attributable to depreciation taken after May 6, 1997.
Rental of Principal Residence
If a taxpayer has ever used their principal residence as a rental property, they may still qualify for partial gain exclusion under Section 121, as long as the ownership and use tests are met. However, the portion of the gain related to rental (nonqualified) use cannot be excluded. The gain must be allocated between the periods of personal use and rental use. Only the portion of the gain attributed to the time the home was used as a personal residence is eligible for exclusion. For example: A taxpayer owns a home for 5 years, living in it for 3 years and renting it out for 2 years before selling it for a $300,000 gain. The rental portion of the gain ($120,000) is calculated by multiplying the total gain ($300,000) by the fraction of time it was rented (2 years ÷ 5 years). That $120,000 cannot be excluded, while the remaining $180,000 (the personal-use portion) qualifies for the gain exclusion. It’s also important to note that any depreciation deductions claimed during the rental period must be recaptured and included in income in the year of sale, even if part of the gain is excluded.
Qualified Opportunity Fund
If a taxpayer has a gain that exceeds the available exclusion, one way to defer the tax is to invest the excess capital gain in a Qualified Opportunity Fund (QOF) within 180 days of the sale. Investing in a QOF allows the taxpayer to defer paying tax on the original gain. The gain is deferred until the taxpayer sells the QOF investment or on the fifth year of the investment, whichever comes first. Please consult your CPA if you are interested in investing in a QOF.
Have questions about how Section 121 applies to your situation? Contact us to discuss your options. Our team is here to help.
