Residential real estate markets are booming and many homeowners are piling up significant unrealized gains. Section 121 provides for a gain exclusion for principal residence sales, and it’s a potentially big tax-saving deal for sellers. So, how exactly does this gain exclusion work?
For a married couple filing a joint return, the exclusion can shelter up to $500,000 of gain from federal income tax. For all other homeowners, the exclusion can shelter up to $250,000 of home sale gain. The current maximum individual federal rate for long-term capital gains is 20% [23.8% if the 3.8% net investment income tax applies]. This assumes no retroactive rate increase on capital gains recognized in 2021 (we are keeping our eyes on the pending legislation that has a 2021 effective date).
What happens if the homeowner has used part of their home for business or as a rental? That part of the gain is carved out and handled separately on the tax return, and there is almost always depreciation recapture as well.
How do I qualify?
Ownership & Use Tests must be passed to take full advantage of the gain exclusion. These are independent tests, they need not overlap. In 2 out of the prior 5 years (from date of sale), the residence must have been used and owned for a total of 730 days as a principal residence.
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The Ownership Test – The home must have been owned for at least two years during the five-year period ending on the sale date.
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The Use Test – The home must have been used as a principal residence for at least two years during the five-year period ending on the sale date.
Principal Residence Definition
When the taxpayer owns multiple homes and occupies them during the same tax year, generally the principal residence for that year is the one where the client spent the majority of the time. Other relevant factors can include:
- Where the client works.
- Where family members live.
- The address shown on the client’s income tax returns, driver’s license, and auto registration and voter registration cards.
- The client’s mailing address for bills and correspondence.
- Where the client maintains bank accounts.
- Where the client maintains memberships and religious affiliations.
Some special circumstances and provisions of Section 121 that can impact the Gain Exclusion:
- Married taxpayers who file separately can potentially qualify for two separate $250,000 exclusions.
- Special Rule for Unmarried Surviving Spouses.
- Anti-Recycling Rule.
- Electing out of the Gain Exclusion can pay off.
- Selling vacant land attached to a Principal Residence can qualify for gain exclusion too.
- Divorce situations and the timing of the sale.
- Conversion of property into a Principal Residence.
- Premature Sale Loopholes: Change of employment, Sale due to health reasons, Sale due to unforeseen circumstances.
