How the Section 121 Exclusion Works for Homeowners
Discover how homeowners can benefit from the Section 121 exclusion to reduce taxable gains when selling their primary residence.
Homeowners selling their primary residence may benefit from the Section 121 exclusion, a tax provision that can significantly reduce taxable gains. This exclusion allows homeowners to exclude up to $250,000 of capital gains for single filers and $500,000 for married couples filing jointly.
Criteria for Claiming the Exclusion
To qualify for the Section 121 exclusion, homeowners must meet specific IRS requirements. The ownership and use test mandates that the property must have been owned and used as the taxpayer’s principal residence for at least two of the five years preceding the sale. These two years need not be consecutive, allowing flexibility for temporary relocations or rentals.
The exclusion can only be claimed once every two years. For instance, if a homeowner claimed the exclusion in 2023, they would not be eligible again until 2025, even if other conditions are met.
Certain life events, such as a change in employment, health issues, or other qualifying reasons, may allow for a partial exclusion. This provision ensures relief for homeowners facing unexpected circumstances.
Calculating Gains
To calculate gains from selling a primary residence, start by determining the adjusted basis of the property. The adjusted basis includes the original purchase price, plus capital improvements, and minus depreciation claimed for business or rental use. For example, if a homeowner purchased a property for $300,000, spent $50,000 on a kitchen remodel, and claimed $10,000 in depreciation, the adjusted basis would be $340,000.
Next, calculate the net selling price by subtracting transaction costs, such as real estate commissions, legal fees, and title insurance, from the gross sale price. For instance, if a home sells for $600,000 and $30,000 in selling expenses are incurred, the net selling price is $570,000.
The realized gain is the difference between the net selling price and the adjusted basis. In this example, the gain is $230,000 ($570,000 – $340,000). Single filers can exclude up to $250,000 of this gain, while married couples filing jointly can exclude up to $500,000.
Handling Multiple Residences
When owning multiple residences, determining which property qualifies for the Section 121 exclusion is crucial. Only one property may be designated as the primary residence. This designation depends on factors such as time spent at each property, mailing address, and family location. For instance, if a homeowner splits time between a city apartment and a suburban house, the property where the majority of time is spent is typically considered the primary residence.
Taxpayers should maintain documentation, such as utility bills, voter registration, and tax returns, to substantiate their primary residence in case of IRS scrutiny. Inadequate proof could result in disqualification of the exclusion and significant tax liabilities.
Converting a secondary residence into a primary one requires meeting the two-year residency requirement before selling to qualify for the exclusion. Planning ahead can help optimize tax outcomes, particularly for the sale of long-held secondary properties.
Partial Exclusion Circumstances
Unexpected life events sometimes necessitate selling a home before meeting the full criteria for the Section 121 exclusion. In such cases, the IRS allows for a partial exclusion. Homeowners may qualify due to significant changes, such as job relocations or health issues.
The partial exclusion is prorated based on the period of ownership and residence. For example, if a single filer lived in a home for one year before a job transfer, they could exclude up to $125,000—half of the $250,000 maximum exclusion. This prorated approach ensures financial relief even when the full criteria aren’t met.
Reporting Requirements
While the Section 121 exclusion provides tax benefits, homeowners must comply with reporting requirements. If the entire gain is excluded and no Form 1099-S (Proceeds from Real Estate Transactions) is issued, the sale may not need to be reported. However, if a Form 1099-S is issued or only part of the gain qualifies for exclusion, the sale must be reported on Form 8949 and Schedule D of Form 1040.
Form 8949 outlines the sale details, including the selling price, adjusted basis, and exclusion claimed. For example, if a home sells for $700,000 and $500,000 is excluded, the remaining $200,000 gain must be reported and may be subject to capital gains tax. Depreciation claimed on the property is generally recaptured and taxed, even if other gains are excluded.
Homeowners should retain supporting documentation for at least three years after filing their tax return. This includes records of the purchase price, receipts for capital improvements, and documents related to selling expenses. For properties with depreciation or partial business use, retaining records for longer periods may be advisable. Proper documentation ensures accurate reporting and provides protection in the event of an audit.