Section 121 exclusion is primarily intended to give owner-occupants a tax break when moving up the property ladder or downsizing homes. It allows you to take up to $250,000 of profit from the sale of your home tax free ($500,000 if married filing jointly). That is, of course, if certain conditions are met. Namely, you must have lived in the home two out of the preceding five years as of the date of sale.
Up until 2009, real estate investors could take advantage of this code by moving into one of their homes, living there for two years, then selling it. As of January 1st, 2009, that loophole has been closed.
While real estate investors can still make full use of the $250,000 / $500,000 maximum Section 121 exclusion, it’s a lot harder to come by. Assuming you pass the other eligibility tests, it all boils down to whether, when, and for how long you lived in the home.
Periods where the home is your principal residence are generally considered “qualified use.” Periods where the home is not your principal residence are generally considered “nonqualified use.” The key subsection here is IRC Section 121(b)(5).
If the Property Was Always Your Primary Home
Congratulations! If you owned and occupied the property for 24 months or longer, and it was your primary residence the entire time you owned it, you qualify for Section 121 exclusion. In that case, kick back and grab a margarita. The following scenarios don’t apply to you.
If All Rental Use Was After You Lived There
Congratulations! If all nonqualified use – such as renting the home – takes place after you move out, then you qualify for Section 121 exclusion. To claim the exclusion, the home must have been your principal residence at least 2 out of the previous 5 years as of the date of sale. Since the nonqualified use must have occurred after move out, this means that the maximum amount of time you can rent the property and still claim the exclusion is 3 years.
The chronological order in which the qualified and nonqualified use occurs is critical in this case. It doesn’t matter whether you lived in the home 24 months or 10 years, as long as the nonqualified use only occurs after the qualified use.
If You Lived in the Property After Rental Use
Let’s say you’ve been renting the property for several years – whether you’ve lived there before or not – and you move in for 2 years before selling it. Here’s where things get tricky.
With few exceptions, “nonqualified use” is defined as any period during which the property is not your principal residence. This means that the period of rental use before you moved in is nonqualified use. (The primary exception is under IRC Section 121(b)(5)(C)(ii)(I) when all nonqualified use occurs after you lived there, which is the previous scenario we covered.)
In this situation, you must apply a nonqualified use ratio to calculate how much of the capital gain is ineligible for exclusion. That ratio is: the total nonqualified use time divided by the total time of ownership. The portion of gain attributable to nonqualified use is ineligible for Section 121 exclusion, but the portion of gain attributable to qualified use can still be excluded from capital gain tax under Section 121.
Example 1: You purchase and live in the home for 2 years, move out and rent it for 5 years, then live there 2 more years before selling for a $300,000 gain. In this case, 5 of the 9 years of ownership were nonqualified use, so 5/9ths of the gain is ineligible for Section 121 exclusion. The remaining 4/9ths of the gain ($133,333) can still be excluded from capital gains tax under Section 121.
Example 2: You purchase a home and rent it out for 7 years, then you move in for 4 years and sell for a $500,000 gain. Here, 7/11ths of the gain is ineligible for Section 121 exclusion, so you can exclude 4/11ths of the gain ($181,818) from capital gains tax under Section 121.
So, how can a real estate investor claim the full exclusion under Section 121?
The nonqualified use ratio is applied to your capital gain before applying the Section 121 cap. This means that if the portion of the gain eligible for exclusion reaches $250,000 / $500,000, then you can still capture the full exclusion under Section 121.
Example 3: You purchase your dream home in Vail and rent it out for 5 years before retiring to move there. You then live in the home for 15 years before selling to downsize. Your gain on the sale is $700,000. In this case, 3/4ths of the gain is eligible for exclusion subject to the Section 121 cap (since you lived there 15 of the 20 years). That works out to $525,000, of which you can exclude $250,000 if filing single or $500,000 if married filing joint.
If You Never Lived in the Property
Sorry, slugger. If the property is never your primary residence, you’re not eligible for Section 121 exclusion. If you’re selling to acquire a new investment property, you could try a Section 1031 exchange to defer capital gains. Alternatively, if you don’t mind keeping the property but you want to pull out some equity, you could try a cash-out refinance.
Of course, you could always just bite the bullet and pay the taxes. It’s not the end of the world. After all, paying taxes means you have income!
Important Legal Junk
This content is not intended as tax, accounting, legal, or financial advice. This information should not be relied upon as the sole factor in an investment or tax related decision. The information on this site is provided “AS IS” and without warranties of any kind either express or implied. Tax code changes frequently, and although we strive to keep our articles up to date, you should consult your tax advisor about how this or any other information is pertinent to your personal situation.