Purchasing a home is one of the largest investments many individuals will ever make. The purchase not only comes with the joy of creating new warm memories, but it also comes with the phenomenal experience of claiming tax benefits. One of the most coveted tax benefits can be found in the exclusion of gain from the sale of the principal residence. The exclusion contained in this section has been part of the code since 1997, and thanks to its inception, it will help you retain a significant amount of your capital gains, and you can use those gains to purchase a new home.
How does the exclusion work?
This exclusion, more fondly known as the section 121 exclusion, allows homeowners to exclude up to $250,000 ($500,000 for joint filers) of capital gain from the sale of their primary residence. After claiming the exclusion, any remaining capital gain is reported to the IRS on Schedule D of IRS Form 1040 or 1040 SR and is subject to capital gains tax.
Note: If you have capital gains to report from the sale of your home, you should provide your tax advisor with IRS Form 1099-S along with any other supporting documentation before the May 17 filing deadline.
Alternatively, if the taxpayer is able to exclude all of the capital gains on the sale, the transaction is not reported to the IRS. That's right -- the entire real estate transaction would be tax-free. That is a huge win in my playbook, and you can take advantage of this every two years if you meet eligibility requirements. It really doesn't get any better than this!
To take advantage of this exclusion, you must first pass a few eligibility tests. I know, no one likes to be tested, but I'm sure most homeowners will score high on this exam. Let's take a look at what you need to do to qualify for the exclusion.
Note: You are ineligible to claim the exclusion if you acquired the property as part of a section 1031 like-kind exchange or if you are subject to expatriate tax.
Test 1: Principal place of residence
To claim the exclusion, the home must have been your principal place of residence during two years of the five-year test period. The IRS considers your principal place of residence to be your main home. Your main home can be a single-family home, a townhouse, a mobile home, a houseboat, etc.
Note: If you're a married taxpayer, to meet the eligibility for the $500,000 exclusion, only one spouse needs to be listed as the homeowner.
No matter the character or shape of the home, you can only have one main home at a time. In general, your main home is the home where you spend most of your time. If you're unable to decide which home this is, the IRS will consider the following factors to decide which home is your primary residence for the purpose of the section 121 exclusion:
- The listed address appears on any one of the following documents:
- U.S. Postal Service address.
- Voter registration card.
- Federal and state income tax returns.
- Valid driver's license.
- Car registration.
- The home is near your social and economic ties, including the following:
- Your place of employment.
- Your bank.
- Your family member's home.
- Your religious institution or community organization.
In addition to the above, the IRS will consider additional factors based upon facts and circumstances to determine which home is the taxpayer’s principal place of residence. So, if you have two homes, make sure you're able to prove to the IRS which home is your main home.
Test 2: Ownership and use
In addition to the principal residence requirement, you must also pass the ownership and use test. To meet the requirements of the ownership and use test, you must have owned and lived in your main house for two years during the last five years prior to claiming the exclusion. The two-year period need not be the last two years prior to the sale but can be any two-year period during the last five-year period. The use can be fulfilled by having owned and used the property for either 24 full months or 730 days during the period of ownership.
Note: If you're married, both spouses must use the property for the specified period, but both individuals do not need to own the property.
Even if the home was converted to a rental property and then converted back to a residential home, you could still qualify for the exclusion so long as you lived in the home for a two-year period. If you fall into this category, it's advisable to work with your tax professional to track your period of personal use.
As you can see, there are two major tests that you need to pass to claim this exclusion: the principal place of residence test and the ownership and use test.
Test 3: Limitation on exclusion claims
While homeowners can claim this exclusion an unlimited number of times, it can only be claimed once every two years. To meet eligibility requirements, you'll need to ensure that you don't claim the exclusion more than once in two years. As promised, these tests are not hard to pass -- truly anyone can do it. While it isn't difficult, there are a few caveats for you to consider.
Exceptions to the section 121 test
There are many exceptions to the general rule. Below we'll review them so you can have a clear idea of your position.
If you're a surviving spouse, the Internal Revenue Code offers you some relief. You may claim the exclusion of up to $500,000 for two years following the date of death of the decedent.
Qualified official extended duty exception
The test period may be suspended if you're on qualified official extended duty in the Uniformed Services, the Foreign Service, or the intelligence community. If you're on extended official duty, the IRS will consider you to have lived in the home even if you were not present in the home during the two-year period.
You may be eligible for a partial exclusion if you experience a health-related move, a work-related move, or any unforeseen circumstances (i.e, death, incapacity, divorce, etc.). If you fall into this category, you will need to work with your advisor to ensure you meet the prongs for the partial exclusion.
Millionacres bottom line
Purchasing a residential property can feel like a dream come true. To keep that dream from turning into a capital gains nightmare, you should always consult your tax advisor before executing a sale. By working with a pro, you'll ensure that you meet the requirements of the IRC section 121 exclusion and fully realize your home-sale dream.