We’ve spent a bit of time covering the basics of Section 1031 on our blog. This is for good reason. Section 1031 is one of the more useful provisions of the tax code. And it’s something every business or investment property owner should be familiar with. One other important real estate tax break is the “primary residence exclusion” (or “principal residence exclusion”) under IRC Section 121. Like Section 1031, Section 121 can be an extremely beneficial tool. Also like Section 1031, Section 121 is all about rules. In this post, we will briefly go over the benefits of the primary residence exclusion and then go over the rules which homeowners have to follow in order to use this tax break.
The Benefits of the Primary Residence Exclusion
Let’s consider a common scenario: a young couple buys a new home – their “starter home” – moves in, and then lives in the home for several years. Then the local real estate market improves, resulting in a dramatic increase in the value of their home. The couple decides to sell their home and purchase a new one. When they go to sell their starter home, they will have a substantial profit given the fact that the home’s value has increased. In this situation, what happens to all the profit? Is all the profit taxable? When you think about it for a moment, taxing the entire profit from the sale of the starter home would seem to be a bit unfair for the young couple. After all, they’re going to need the money from the sale to turn around and buy a new house. This is where Section 121 comes into play.
As long as they follow the rules, the couple will be able to eliminate a certain amount of the “gain” (or profit) from the sale of the starter home. Presently, the maximum amount of gain which can be excluded for individuals is $250,000, and for married couples filing jointly it is $500,000. This means that if the couple originally purchased the starter home for $500,000, and then it appreciated to $1 million, the couple would be able to use Section 121 and receive the entire $1 million tax free. This is because the other $500,000 not eliminated by Section 121 is part of the home’s “cost basis,” meaning it is the price the couple originally paid for the home, and so it is considered nontaxable income.
The Rules of the Exclusion
In order for the couple to use this exclusion, they have to follow a number of rules. It’s a tax break, so this really shouldn’t surprise us. The tax code is all about rules, which is one reason why your accountant’s bill can be quite high when tax filing time rolls around. The main rule of Section 121 is that the home must be the dwelling place of the taxpayer for a minimum of 2 years in the most recent 5 year period. This 2 year period doesn’t need to be sequential, but can be made up of multiple separate periods of time during the most recent 5 year period. This means that if the couple lives in their starter home for 1 year, and then resides elsewhere for another year, and then moves back into the starter home for 1 year, the starter home would satisfy the 2 year ownership requirement. If, on the other hand, instead of residing elsewhere for a year, the couple resided elsewhere for 5 years, then the starter home couldn’t be used for Section 121 purposes.
Again, this is the main rule, but there are others as well. Section 121 has complex rules when a home is converted into a primary residence after being used for a separate purpose beforehand. For instance, if a person buys a property and uses it as a rental home, but then converts that rental home into a primary residence 3 years later, then that person may not be able to use the maximum exclusion provided by Section 121. In that situation, the person would need to compute the fraction of their gain eligible for exclusion, and that fraction would be a function of how much “non-qualifying use” (meaning use other than as a primary residence) occurred using the property. There are other rules too, and in a later post we may return to this topic and discuss in detail some of these other rules. But for now, this is a good introduction to the basic requirements and purposes of Section 121.
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