Section 121 Exclusion: Explained
The real estate market is bombing at the moment. Many homeowners with large appreciation are afraid of selling their homes because of the tax consequences associated with such sales.
However, the tax burden that comes with gains on the sale of a home can be eliminated or reduced through Internal Revenue code Section 121.
Section 121 allows for the exclusions of up to $250,000 from capital gains if filing individually or $500,000 if you’ve filed jointly with your spouse. Gain in excess of this exclusion is still subject to tax. This exclusion applies specifically to gains seen on the sale of real estate property but comes with some caveats.
In order to take advantage and qualify of the Section 121 exclusion, there are some timing guidelines that must be followed.
Eligibility starts with the “Ownership & Use Test”. It ensures that the property being sold is in fact the main residence of the seller. This test is passed when you’ve owned and used the property as your home base for at least two out of the last five years prior to the date of sale of the property. It’s important to note that this two year period does not need to be continuous.
Some exceptions from eligibility for exclusion also exist. If you’ve already excluded the gain from the sale of another home during the two-year period prior to the sale of your home, you are not eligible from claiming the exclusion again. However, if it has been over two years, you may be found eligible for the exclusion if you meet the criteria.
The 5-year test period may be extended under special circumstances, for example if you are an officer in uniformed, foreign, or intelligence services. There are also special guidelines to follow under this exception.
An example of this exclusion in action can be found below:
You purchase a house for $500,000
After living in the house for at least two of the past five years, you sell the house at a gain for $800,000
Gain on sale of house = $800,000 - $500,000 = $300,000
Taxable gain after Section 121 Exclusion = $300,000 - $250,000 = $50,000 (if filing individually)
Section 121 is a great exclusion that homeowners can take advantage of. When paired with something like the 1031 Exchange, it offers a great incentive for people to invest and rent their property. Of course, it is always smart to consult with a tax professional for guidance on qualification and eligibility.
