Joseph Sachetta
Is there any chance you’ll sell your home soon? If so, maximizing your Section 121 exclusion needs to be part of the planning process for the sale. This provision allows qualified homeowners to exclude as much as $500,000 in capital gains from taxation after the sale of their primary residence. Considering the maximum capital gains tax rate of 20%, a section 121 exclusion may present a six-figure tax savings opportunity—depending on eligibility. As always, speak to your tax and financial planning advisors for specific guidance before selling your home.
WHAT SHOULD HOMEOWNERS KNOW ABOUT A SECTION 121 EXCLUSION?
It’s only available for primary residences.
A section 121 exclusion can’t be applied to capital gains incurred from the sale of a vacation home or investment real estate.
The maximum exclusion is $250,000 for unmarried taxpayers, or $500,000 for a married couple filing jointly.
Any portion of a capital gain that exceeds the exclusion cap will be taxed. So, a qualified married couple who recognize a capital gain of $450,000 on the sale of their home would pay no capital gains tax on the sale. If they recognize a capital gain of $600,000, they would be taxed on the $100,000 above the exclusion amount.
(Note that a section 121 exclusion doesn’t apply in cases of capital losses. If you sell your primary residence for less than you paid, the loss is generally going to be nondeductible.)
Eligibility hinges on passing an ownership test and use test.
The IRS has two requirements that a home seller must meet in order to claim the maximum section 121 deduction. Working backward from the date of the sale, you need to have owned the home for at least 24 months out of the previous five-year period. If you’re married and filing jointly, it’s okay if only one spouse meets this requirement.
The “use test,” or residence requirement, requires that you used the home as your primary residence for at least 24 months out of the previous five-year period. Both spouses must meet the residence requirement to claim the maximum $500,000 deduction. So, if one person owned a house for many years and their new spouse only moved in 12 months before they decided to sell, this couple would only be able to shield $250,000 in capital gains from taxation.
Partial exclusions may be available when circumstances force the sale of your home.
The IRS allows these partial exclusions in cases where someone needs to move because of work, health and/or unforeseeable events. As examples, let’s say you bought your home a year ago. Then your job transfers you to another city. Or you want to move so you can take care of an ailing parent, or because you became disabled and your home isn’t accessible. Despite not meeting the ownership and residency requirements for a full section 121 exclusion, you may be able to shield at least some of your capital gain from taxation. Your exclusion limit would be determined by how long you owned/resided in the residence.
EXCEPTIONS RELATING TO SECTION 121 EXCLUSIONS
- You’re selling your primary residence as part of divorce or separation proceedings: A divorce always changes your financial plans. When the home sale is related to the dissolution of a relationship, the specific circumstances will dictate how both parties and their tax planners manage the tax implications of the sale. If spouse A transfers their share of a jointly-owned property to spouse B as part of a divorce settlement, there’s no capital gain for spouse A to recognize. If the spouses jointly sell, each may be eligible for individual exclusions of $250,000. These details should be figured out and included in the divorce decree ahead of the sale of the property.
- You or your spouse was an active-duty service member: The standard five-year residency requirement may be extended by 10 years for a homeowner who is away on active duty as part of military or Peace Corps service.
- Your spouse died: The death of a spouse may affect a seller’s eligibility for a section 121 exclusion, depending on circumstances. First, let’s say that you and your spouse both met the 24-month ownership and residence requirements for your primary home. If you sell the home within two years of the death, and haven’t remarried, you may be eligible for the full $500,000 exclusion. Remarrying, and/or waiting more than two years after the death to sell, would likely restrict you to a maximum exclusion of $250,000. Keep in mind that upon death, if the residence is includible in the estate of the deceased, there will most likely be a full or partial step up in basis equal to the fair market value of the property as of the time of death, reducing the gain on sale.(Addressing plans for the future of your primary residence may also be part of estate planning for someone with a terminal illness.)
BEFORE SELLING YOUR PRIMARY RESIDENCE, LET’S TALK TAX STRATEGY.
Section 121 exclusions are just one of the tax planning topics that homeowners need to discuss with their advisors before selling a primary residence. Maximizing deductions related to a home sale, accurately calculating your home’s basis, strategizing about the tax implications of buying vs. renting your next home, and updating estate plans are just some of the things a seller might need to address with their advisors. Even if you’ve sold a primary residence in the past, ever-evolving tax law makes each sale different.
Sachetta’s accounting and tax team and financial planning team often work with homeowners to design efficient tax strategies ahead of a home sale. If you’re thinking about selling your primary residence, let’s make sure you’re able to claim the maximum section 121 exclusion available to you. Contact us today.
Joseph Sachetta, CFP®, CPA/PFS, MBA, MST, For over 40 years, Joe has worked in finance and accounting. He is a Certified Financial Planner, and a Certified Public Accountant. Joe’s passion lies with helping his clients strike a balance between living for today and saving for tomorrow.