By Greg Gockel, CPA, Manager, Tax & Advisory
ASL Real Estate Group
Selling your home is not just a transaction, it’s an opportunity to leverage tax strategies that can significantly impact the financial results of the sale. If the sale is correctly planned, using the power of Internal Revenue Code Section 121, you will be able to exclude up to $500,000 (couples) or $250,000 (individuals) of your capital gains. This article will coach you as we dive into some of the rules and exceptions and discuss some strategies to help maximize your tax benefits.
Determining Your Principal Residence
The first thing you need to consider is “where is my principal (or primary) residence” as the exclusion is only available for the sale of your current or prior primary residence.
In regards to the §121 exclusion, you can only have one principal residence even if you own multiple properties that you may call home. Typically, your principal residence is where you spend the most time. Some other relevant factors to consider are:
- Your job location
- Where do your family members live?
- What address is reported on your tax returns, driver’s license, and car registration?
- Where do your bills get mailed to?
- The location of your bank
- Where you attend church or go to social events?
Full or Partial Exclusion
After you have established your principal residence, you need to determine if you qualify for the “full or partial” exclusion. To qualify for the full or the maximum exclusion, you must pass the following tests.
- Ownership Test – owning the home for 2 out of the last 5 years (if married, only one spouse needs to qualify).
- Use of Residence Test – using the home as your principal residence for 2 out of the last 5 years (if married, both spouses need to qualify).
- Lookback Test – you did not take the exclusion in the 2-year period before the sale.
- Common situations where modified rules may apply to the tests above:
- A separation or divorce occurred during the ownership of the home.
- The death of a spouse occurred during the ownership of the home.
- Your previous home was destroyed or condemned.
- You used the entire property as a vacation home or rental after 2008 or you used a portion of the home, separate from the living area, for business or rental purposes.
- The home was acquired in a like kind exchange during the past 5 years.
If you were not able to meet all the eligibility tests above, you’re not out of luck. You may still qualify for a “partial” exclusion. A partial exclusion may apply if the reason for the sale was related to any of the following:
- A change in workplace location of at least 50 miles from the previous location.
- A health issue for you or a family member.
- An “unforeseeable event” as described in IRS guidance.
Partial Exclusion Example
John, a San Jose homeowner, had to sell his home for a gain after living in it for 18 months and move to El Dorado Hills for health-related issues. Even though John did not meet the 2-year test, as a result of the health issues, he is still able to qualify for a 75% partial exclusion (18 months owned as your main home over 24 months or 2 years).
Non-Qualified Use
Generally, you will not be able to get the full gain exclusion from the sale of your home where you used the home or a portion of your home for business or rental where there is “non-qualified use”. Non-qualified use means any period after 2008 when the property was not used as your main home. Fortunately, there are some exceptions that may apply here as well. Non-qualified use does not include:
- Any portion of the 5-year period ending on the date of the sale or exchange after the last date you used the property as your principal residence. Using this exception you can still qualify for a full exclusion if you have only rented your home for a few years before selling.
- Any period (not to exceed 10 years) during which you (or your spouse) are serving on qualified official extended duty or any other period of temporary absence (not to exceed an aggregate period of 2 years) related to the partial exclusion reasons noted earlier.
- Additional exceptions apply when there was only a portion of the home used for business or rental use.
Transitioning from a Principal Residence to a Rental
As the eligibility tests and exceptions can be difficult to navigate, it is important to consult with a tax professional when you are considering a home sale. Now that we have discussed many of the rules, restrictions and exceptions that apply, let’s delve deeper into some practical considerations.
A common question that typically arises when your property transitions from a principal residence to a rental and vice versa is, what do you qualify for as far as the §121 exclusion is concerned?
Initially, when the property served as your principal residence, the ownership and use tests were straightforward. You needed to own the property for at least two out of the last five years and use it as your main home during the same period. This sets the foundation for potential exclusions.
Timing is extremely important. Those two years of primary residence use don’t have to be consecutive, giving you the flexibility to strategically plan your sale. While there is flexibility, there are situations that will disqualify your exclusions, such as a sale of another home where the §121 exclusion was taken during a 2-year period before the date of the current sale.
In the event your property has transitioned from a primary residence to a rental, you can still benefit from the gain exclusion. Let’s look at several possible scenarios.
Tony, a married homeowner, lived in his home for 2 years and subsequently converted his primary residence to rental property for the next 35 months. In month 36, Tony sold the property at a gain of $500k. Even though he rented out the property, the 35 month rental period is not considered non-qualified use as the timing is after the 2-year period when it was his primary residence. As a result, the $500k gain will be excluded from Tony’s capital gains.
If Tony sold the rental property after 36 months or 3 years of rental use, he would not meet the 2 out of the last 5 years residence test. In this scenario, Tony would have a $500k taxable gain. As you can see, the timing of the sale can have a significant tax impact.
Transitioning from a Rental to a Principal Residence
Now let’s walk through an example with Jane where the property is a rental converted into a primary residence. Jane moved into her rental property after a 3-year rental period, making it her home. At the end of living in it for 2 years as her principal residence, she sells her home. In this situation, the ownership and use tests changed. As she owned the property as a rental before the use as a principal residence, the percentage of non-qualified use time (the 3 years as a rental property) over the 5-year period or 60% of the gain will not be eligible for the §121 exclusions.
By understanding these nuanced rules and real-life examples, you can make informed decisions, ensuring you plan your sale strategically while maximizing the benefits of §121.
A Tax Deferred Exchange
Now, let’s add another wrinkle to planning for a home sale. Have you found yourself thinking of upgrading or diversifying your real estate holdings? If your primary residence has been converted to a rental property, a tax deferred exchange may allow you to expand your property portfolio. The Tax Code allows you to defer capital gains taxes by reinvesting the proceeds from the sale of a rental property into another qualifying property (for more information, continue reading Capital Gains Tax Issues – 1031 Exchange Variations and Alternatives). It’s a double play if the sale is structured to use the §121 exclusion to receive tax free cash from the sale in addition to deferring gain with an exchange.
Our team of experts is here to advise you on getting the best tax benefits from the sale of your current or former residence. Contact us for personalized guidance and discover how you can turn your home sale into a tax-saving home run.