Can an Estate Use the Section 121 Exclusion?

When an individual passes away, the executor or heir is often tasked with selling the family home, raising questions about capital gains tax. Homeowners can use a tax exclusion to shield profits from the sale of their primary residence from taxation. A key question for those managing a deceased person’s affairs is whether an estate or heir can benefit from this same tax break. The answer depends on the specific circumstances of the property’s ownership and sale.

Understanding the Section 121 Exclusion

Section 121 of the Internal Revenue Code allows a taxpayer to exclude a substantial amount of gain from the sale of their main home. A single individual can exclude up to $250,000 of gain from income. This amount doubles to $500,000 for a married couple filing a joint tax return, provided certain conditions are met.

To qualify for the exclusion, a taxpayer must meet both an ownership test and a use test. The ownership test requires owning the home for at least two of the five years leading up to the sale date. The use test requires living in the property as a principal residence for at least two of the five years before the sale. These two-year periods do not have to be continuous, but both tests must be met within the five-year window.

These rules ensure the tax benefit is for a primary home, not a vacation or rental property. A taxpayer can only claim the exclusion once every two years. If a taxpayer sells another home and uses the exclusion, they must wait two years before using it again.

If a taxpayer receives a Form 1099-S, “Proceeds From Real Estate Transactions,” they must report the sale to the IRS on their tax return. The sale is reported on Schedule D and Form 8949 of the Form 1040, even if all the gain is excludable.

The Role of Stepped-Up Basis in Inherited Property

For many heirs selling a home soon after a person’s death, the most important tax provision is the “stepped-up basis.” Under Section 1014, the cost basis of an inherited asset is adjusted to its fair market value (FMV) on the date of the original owner’s death. This rule can reduce or eliminate the capital gains tax owed upon sale.

The cost basis is the value from which capital gain or loss is calculated. Without the step-up rule, an heir would assume the decedent’s original cost basis, potentially leading to a large taxable gain. The stepped-up basis erases the appreciation that occurred during the decedent’s lifetime for income tax purposes.

For example, imagine a person bought a home for $100,000 that has a fair market value of $600,000 at their death. The heir receives a new, stepped-up basis of $600,000. If the heir sells the home for $610,000, their taxable capital gain is only $10,000, not the $510,000 gain that would exist otherwise.

This basis adjustment happens automatically for property in the deceased’s gross estate. An executor can elect to use an alternate valuation date, which is the property’s FMV six months after death, if the value of assets has decreased. Because the stepped-up basis often eliminates most capital gain, the Section 121 exclusion may not be needed.

Eligibility of an Estate or Trust for the Exclusion

When a person dies, their property passes into their estate, a separate legal and tax-paying entity that files Form 1041, “U.S. Income Tax Return for Estates and Trusts.” An estate generally cannot claim the Section 121 exclusion when it sells the decedent’s home. The reason is that an estate, being a legal entity, cannot live in a house and therefore cannot satisfy the personal use test.

This rule means if a home is sold by the estate, any gain from post-death appreciation is taxable to the estate. While the stepped-up basis minimizes gain, any increase in value between the date of death and the sale date is taxed. For example, if a home valued at $600,000 at death is sold by the estate a year later for $650,000, the estate has a $50,000 capital gain to report.

An exception exists if the home was held in a specific type of trust, such as a revocable living trust. If the trust is classified as a “grantor trust,” the law treats the grantor as the owner for income tax purposes. Under Treasury Regulation 1.121-1, if the deceased grantor met the ownership and use tests before death, the trust can claim the exclusion on a post-death sale. This allows the trust to shield up to $250,000 of gain.

Tax Considerations for Heirs Selling the Property

The tax implications change if the estate distributes the home to an heir, who then sells it. The heir receives the property with a stepped-up basis, resetting their basis to the fair market value at the time of the original owner’s death. For an heir to claim the Section 121 exclusion, they must independently meet the ownership and use tests. This requires the heir to move into the inherited house and make it their primary residence for at least two years before selling.

The tax code allows an heir to “tack on” the decedent’s period of ownership to their own to meet the ownership test. However, this tacking rule does not apply to the use test. The heir cannot count the time the decedent lived in the home to meet their own two-year residency requirement.

A more favorable rule exists for a surviving spouse. An unmarried surviving spouse may claim the full $500,000 exclusion if the sale occurs within two years of the other spouse’s death. To qualify, the couple must have met the joint requirements for the exclusion immediately before the death. A surviving spouse can also count the deceased spouse’s period of ownership and use as their own.