In 1997 the Taxpayer Relief Act introduced some significant changes to the tax rules that applied to the sale of a personal residence. Over a decade later, those rules were updated with the passage of The Housing and Economic Recovery Act of 2008 which included a provision that amends Section 121 of the Internal Revenue Code.
What does this mean for you?
Section 121 of the Internal Revenue Code, which is often referred to as the 121 exclusion, generally allows homeowners to sell real property held (owned) and used (lived in) as their primary residence and exclude up to $250,000 in capital gains from their taxable income per homeowner, and up to $500,000 in capital gains for a married couple filing a joint income tax return.
But how is primary residence defined?
The 121 exclusion can only be used in conjunction with real property that has been held and used as the homeowner’s primary residence. It does not apply to second homes, vacation homes, or property that has been held for rental, investment or use in a trade or business.
To qualify, homeowners are required to have (1) owned and (2) lived in the real property as their primary residence for at least a combined total of 24 months out of the last 60 months (two out of the last five years) in order to qualify for the 121 exclusion. The 24 months does not have to be consecutive and homeowners can take advantage of the 121 exclusion once every two years. As always, there are certain exceptions to the 24 month requirement when a change of employment, health, military service or other “unforeseen circumstances” have occurred. You can see your tax advisor to discuss the exceptions.
It should be noted that the 121 exclusion allows homeowners to exclude capital gains but not depreciation recapture from their taxable income when they sell their primary residence that was also held as an investment property. The depreciation recapture would be recognized in the year the primary residence is sold even if the homeowner qualifies for the 121 exclusion.
What changes were made to Section 121 in 2008?
The Housing and Economic Recovery Act of 2008 amends Section 121 of the Internal Revenue Code so that Section 121 no longer permits homeowners to take the full tax-free exclusion on the sale of real property that was held and used as their primary residence if there was any non-qualified use of the real property prior to its being held and used as their primary residence. Non-qualified use only applies after January 1, 2009. This change makes it important for homeowners to understand the difference between qualified and non-qualified use.
Qualified use is defined as any use of the property as a primary residence. Non-qualified use is defined as any use of the property other than as a primary residence, including use as a second home, a vacation property, a rental or investment property or use in a trade or business.
This means homeowners can no longer take the full tax free exclusion under Section 121 when the property was held and used for non-qualified use prior to its being held and used as a primary residence (qualified use).
The capital gain resulting from the sale of the property will be allocated between qualified and non-qualified use periods based upon the amount of time the property was held and used for qualified versus non-qualified use.
The capital gain allocated to the non-qualified use period will no longer be excluded from the homeowner’s taxable income. The capital gain allocated to the qualified use period (time used as a primary residence) will continue to qualify for the 121 exclusion and will be excluded from the homeowner’s taxable income.
What calculations are needed?
Homeowners do not need to determine when the property actually appreciated or depreciated in value. There are no appraisals needed or required. The change or fluctuation in the fair market value of the property each year during the time they owned it doesn’t matter. The total capital gain recognized upon the actual sale of the property is all that matters.
The total capital gain recognized upon sale will be allocated between qualified and non-qualified use periods in order to determine the amount of gain to be excluded from taxable income under Section 121 of the Internal Revenue Code due to qualified use, and the corresponding amount of capital gain that will be included in taxable income (not excluded) under Section 121 due to non-qualified use.
Gain is allocated using a formula or fraction based on the number of years the property was held for qualified use versus the number of years the property was held for non-qualified use as a percentage of the total number of years the property was owned by the homeowner.
Why should you consider combining Sections 1031 and 121?
Strategies of combining the 1031 exchange and the 121 exclusion have become very popular over the last few years, especially after the American Jobs Creation Act of 2004 was enacted by Congress and after the Internal Revenue Service issued Revenue Procedure 2005-14, both of which helped clarify the homeowner’s ability to use the combined 1031 exchange and 121 exclusion strategies.
The combined strategies enabled homeowners to convert tax-deferred income into tax-free income.
Generally, homeowners have been structuring and implementing three different income tax strategies, which involved converting real estate between investment (rental) and primary residence usage. The three combined income tax strategies included:
- Rental property that was never part of a prior 1031 exchange is converted into a primary residence. The homeowner converts the rental property into the homeowner’s primary residence. The homeowner must live in the property for at least 24 months in order to qualify for the 121 exclusion. The homeowner can then sell the primary residence and take the 121 exclusion.
- Rental property that was acquired as part of a prior 1031 exchange is converted into a primary residence. The homeowner converts the rental property into the homeowner’s primary residence. The homeowner must live in the property for at least 24 months in order to qualify for the 121 exclusion. Because the rental property was part of a prior 1031 exchange the homeowner must also have owned the property for at least five years in order to take advantage of the 121 exclusion. The homeowner can then sell the primary residence and take the 121 exclusion.
- The homeowner’s primary residence is converted into rental property. The homeowner should hold the property as investment (rental) property for at least 12 months in order to prove they had the intent to hold the property for investment use and qualify for 1031 exchange treatment. The homeowner can then sell the rental property and take the 121 exclusion (provided they qualify for the 121 exclusion) and they can complete a 1031 exchange to defer the balance of the capital gains not excluded under Section 121. This strategy is defined in Revenue Procedure 2005-14.
This is a lot of detailed information to consider, but understanding the opportunities for leveraging the 121 exclusion can make a significant difference for homeowners considering a sale of their primary residence!