IRC 121 exclusion provides that when you sell your “principal house”, you may be able to exclude a portion or all of the gains from your income, thanks to specific provisions in the U.S. tax code. Section 121 of the Internal Revenue Code provides a specific exclusion for capital gains realized on the sale of a principal residence. Tax law distinguishes types of residence for income exclusion purposes, please read this.
Who is eligible for 121 Exclusion?
To qualify for the Section 121 exclusion, the following three fundamental conditions must be fulfilled.
- The ownership of the sold home must be for at least two years during the five years ending on the date of the sale.
- You are living in your principal residence for at least two out of the five years preceding the sale. These two years of residency do not need to be consecutive.
- You have not claimed any home sale exclusion within the two years immediately preceding the sale.
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What are the exceptions to the rule of living in the principal house?
However, the rule that you must live in your primary residence for two years out of five years preceding the date of sale has certain exceptions. Like
- If the house sale was due to a job relocation and the new job location is 50 miles farther from the old home than the old job location was.
- If the sale of the house was primarily due to health reasons. For example,you had to sell the house to move closer to the medical centre for yourself or your family member’s treatment.
- Apart from the exception described above, the IRS has provided specific examples of what might be considered “unforeseen circumstances,” in Publication 523, “Selling Your Home”, which are listed below :
- Death of the homeowner or a qualified individual (such as a spouse or co-owner) passes away.
- On divorce or Legal Separation
- If the homeowner gives birth to multiple children from the same pregnancy.
- If the home suffers from natural or man-made disasters that result in a casualty to the residence.
- Change in Employment Status results in the homeowner’s inability to pay housing costs and reasonable basic living expenses and become eligible for unemployment compensation.
- If the primary reason for the sale is related to the homeowner’s health or the health of a qualified individual which doesn’t meet the regular health-related sale condition. This could include the onset of a health condition not previously present.
Readers should note that the IRS has the discretion and flexibility for unexpected life events not explicitly listed in the regulations. So, it would help if you had plausible reasons that compelled you to dispose of the property.
What is the Maximum 121 Exclusion Amount?
If you meet the eligibility requirements, the maximum exclusion for the year 2023 is as follows:
- Single Filers: Can exclude up to $250,000 of gain.
- Married Couples Filing Jointly: Can exclude up to $500,000 of gain.
What happens if you don’t meet the full two-year requirements?
If you don’t meet the full two-year requirements because of exceptional circumstances, you may still qualify for a reduced maximum exclusion, proportional to the time you lived in the residence.
For example, if you, a single filer, lived in your primary residence for nine months before selling due to a health issue. In that case, you could potentially exclude 9/24th of $125,000=$46,875
How do you count the period of ownership in Special Situations?
IRC provides three circumstances- Death, Divorce and multiple properties’ ownership – in which the counting of ownership period has special rules.
(i) Property received as part of the divorce settlement.
If you receive a home in a divorce settlement, you can count any time your former spouse owned the home towards the ownership test. If both ex-spouses meet the use test, both can qualify for the exclusion when selling the house.
(i) Property received on Death of actual owner.
If a spouse dies and the surviving spouse has not remarried by the sale date of the home, the deceased spouse’s time of ownership and use can be attributed to the surviving spouse.
iii) If you are the owner of multiple Properties
Only one home can be designated as the primary residence at a time. If you have multiple properties, consider which one to claim as your primary residence based on your living situation and potential gains.
(iv) Residence acquired on 1031 exchange
As per Section 121(d)(10), when the residence is acquired through a tax-deferred (Sec 1031) exchange, the residence must be owned for five years before its sale to qualify for the exclusion for being eligible for 121 exclusion.
How to Maximize Section 121 Exclusion
The Internal Revenue Code does not limit the number of times you can use the exclusion as long as the three conditions, as stated earlier, are fulfilled. So, if you follow the rules strictly, the joint filer can claim a $ 1,500,000 exclusion in a year. Here are the steps :
- Start by selling your current home because you probably already meet the two-out-of-five-years ownership and use tests.
- If you have a second home, the next step would be to move into it and make it your primary residence. After you have lived there for two full years and it has been more than two years since the previous home was sold, you can sell the property and take the home sale exclusion again.
- The third step is to buy a fixer-upper home and occupy it. You start staying and improving the house to make it a saleable house that can fetch a good amount over two to three years. You can sell the fixer-upper and take the third exclusion when that time is up.
This way, a married couple can exclude as much as $1,500,000 of home sale profit in just over four years if they abide by the rules & time the sales correctly.
What if you own & stay in a rental property?
If you own a rental property and occupy it for two years before its sale, you can also exclude a portion of the gain for that property.
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