How would you like to pay no (or less) tax on the sale of your home, even if it appreciated in value?
Whether you’re making a move for work, starting a family and needing to upsize, empty nesters looking to downsize, looking for a change in scenery, etc., you can avoid a substantial amount, if not all, of your capital gains tax on the sale.
Is This Real?
Yes, it’s real, and it’s called the Section 121 exclusion. More commonly, it’s known as the 2-out-of-5 year rule.
Section 121 of the Tax Code states that you can exclude from gross income up to $250,000 ($500,000 for married individuals filing a joint return) of the gain on the sale of a property if you meet the ownership and use requirements.
The ownership requirement is, believe it or not, that you must own the property.
The use requirement is that you have to have lived in the property for at least two out of the past five years. That means any two-year period. It doesn’t have to be consecutive and you don’t have to be living there at the time you sell.
For example, you can live there for a year and a half, rent it out for two years, move back for six months, move out and rent it for another year, and then sell, and you would still qualify for the exclusion.
That sounds pretty good to me.
Got Married Recently?
The exclusion doubles from $250,000 to $500,000 for married couples. But what happens if you get married within the five-year look back period?
Both spouses would have to meet the use requirement, but only one spouse needs to meet the ownership requirement. In other words, both spouses have to have lived in the property for at least two out of the last five years, but only one spouse has to actually own it.
For example, if you buy a property, live in it for a year by yourself, move out and rent it out for 2 years, get married and move back in for 2 years before selling, you would be able to exclude $500,000; one spouse meets the ownership requirement and both spouses meet the use requirement.
Be Careful When Converting a Rental to a Principal Residence
The Section 121 exclusion is pretty straightforward when dealing with properties you first acquired as your principal residence and then converted to a rental. When a property that was initially purchased as an investment is converted to a principal residence, it could get a little tricky.
If you rented the property before you first lived in it, you have to allocate a portion of the exclusion amount ($250,000 or $500,000 if married filing jointly) to the “period of nonqualified use”, which is calculated by dividing the period of nonqualified use by the total period you owned the property.
Period of nonqualified use is defined in Section 162(b)(5)(C)(i) as:
…any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.
The period of nonqualified use does not, however, apply to a period of time in which you did not occupy the property after you have initially lived there.
A little bit confusing, I know.
But, hopefully, you’re not as confused as this:
Basically, the period of nonqualified use relates to the period of time you did not occupy the property before ever living there in the first place.
You bought an investment property 10 years ago and rented it out for the first 7 years. In the 8th year, you moved in and converted it to your principal residence. You lived there until you sold it in Year 10.
The period of nonqualified use would be 7 years, and the period of qualified use would be 3 years.
So, 70% (7 years of nonqualified use divided by 10 years of ownership) of the gain realized on the sale would be attributable to nonqualified use and, therefore, would not qualify for the exclusion; you would only be able to exclude 30% of your gain (up to $250,000 or $500,000, depending on your filing status).
You bought an investment property 5 years ago and rented it out for the first 2 years. In the 3rd year, you moved in and converted it to your principal residence. You lived there for two years (Years 3 and 4) and moved back out in Year 5. You rented it for one more year and sold it at the end of Year 5.
In this example, the period of nonqualified use would be 2 years, and the period of qualified use would be 3 years.
The last year you rented it out (Year 5) is not considered a period of nonqualified use because you had lived in the property prior to renting it out (Years 3 and 4).
So, 40% (2 years of nonqualified use divided by 5 years of ownership) of the gain realized on the sale would be attributable to nonqualified use and, therefore, would not qualify for the exclusion; you would only be able to exclude 60% of your gain (up to $250,000 or $500,000, depending on your filing status).
Two important limitations to keep in mind are:
- You can only use this exclusion once every two years.
- The exclusion does not apply to depreciation recapture; it only allows you to exclude capital gains from your income.
“Stop the Clock” Exception for Members of the Uniformed Services
Military personnel and spouses of military personnel on “qualified extended duty” can suspend the 5-year test period for up to an additional 10 years. Therefore, the use requirement becomes 2 out of 15 years, contingent on the fact that you were away from your home due to being on qualified extended duty.
Publication 523 says you are on qualified extended duty if:
- You are called or ordered to active duty for an indefinite period, or for a definite period of more than 90 days.
- You are serving at a duty station at least 50 miles from your main home, or you are living in government quarters under government orders.
- You are one of the following:
- A member of the armed forces (Army, Navy, Air Force, Marine Corps, Coast Guard);
- A member of the commissioned corps of the National Oceanic and Atmospheric Administration (NOAA) or the Public Health Service;
- A Foreign Service chief of mission, ambassador-at-large, or officer;
- A member of the Senior Foreign Service or the Foreign Service personnel;
- An employee, enrolled volunteer, or enrolled volunteer leader of the Peace Corps serving outside the United States; or
- An employee of the intelligence community, meaning:
- The Office of the Director of National Intelligence, the Central Intelligence Agency, the National Security Agency, the Defense Intelligence Agency, the National Geospatial-Intelligence Agency, or the National Reconnaissance Office;
- Any other office within the Department of Defense for the collection of specialized national intelligence through reconnaissance programs;
- Any of the intelligence elements of the Army, the Navy, the Air Force, the Marine Corps, the Federal Bureau of Investigation, the Department of Treasury, the Department of Energy, and the Coast Guard;
- The Bureau of Intelligence and Research of the Department of State; or
- Any of the elements of the Department of Homeland Security concerned with the analyses of foreign intelligence information.
You can only suspend the 5-year test period for one property at a time.
Section 121 Exclusion and 1031 Exchanges
If planned correctly, you can utilize both the Section 121 exclusion and 1031 exchange on the same property, as clarified in Rev. Proc. 2005-14. Talk about the ultimate tag-team tax savings duo.
This topic requires careful planning and strategizing; if you are thinking about selling your property and want more info on how to take advantage of both of these tax saving opportunities, contact your CPA to find out more.
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Nick Aiola is a CPA located in New York, NY. Nick provides the highest quality of tax and accounting services to a wide range of clients, including individuals, businesses, and fiduciary entities.
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