Section 121 Exclusion After the Death of a Spouse

The sale of a primary residence can result in a substantial tax bill on the profit. Homeowners, however, can benefit from a tax provision known as the Section 121 exclusion, which allows taxpayers to exclude a large portion of the gain from their taxable income.

Core Requirements for the Section 121 Exclusion

To qualify for the home sale exclusion, a taxpayer must satisfy two tests from the Internal Revenue Service (IRS). The first is the Ownership Test, which requires owning the home for a cumulative total of at least two years within the five-year period ending on the date of the sale. These 24 months do not need to be continuous.

The second requirement is the Use Test, mandating the taxpayer lived in the property as their principal residence for at least two of the five years leading up to the sale. Similar to the ownership test, the 24 months of use do not have to be consecutive. The periods of ownership and use do not need to overlap.

Under these rules, a single individual can exclude up to $250,000 of gain, while married couples filing jointly can exclude up to $500,000. To be eligible for the larger exclusion, at least one spouse must meet the ownership test, but both spouses must meet the use test.

Special Rules for a Surviving Spouse

The tax code provides specific considerations for a surviving spouse selling a primary residence. A widow or widower may be eligible to claim the full $500,000 exclusion if the home is sold within two years of the date of the other spouse’s death.

To qualify for this provision under Internal Revenue Code Section 121, the couple must have met the requirements for the $500,000 exclusion immediately before the death occurred. This means both spouses met the use test, at least one met the ownership test, and neither had used the exclusion on another home sale within the preceding two years. The surviving spouse must also not have remarried before the date of the sale.

If the sale takes place more than two years after the spouse’s death, the exclusion amount reverts to the single filer limit of $250,000. However, the surviving spouse is permitted to include any time the deceased spouse owned and lived in the home as their own. This “tacking” provision helps the survivor meet the two-year ownership and use tests.

Calculating Gain with Stepped-Up Basis

Determining the capital gain on a home sale requires knowing its tax basis: the original purchase price plus the cost of any significant improvements. When a homeowner dies, a rule called “stepped-up basis” adjusts the property’s basis to its fair market value (FMV) on the date of death. This adjustment can significantly reduce the taxable gain on a subsequent sale.

The application of the stepped-up basis rule differs depending on whether the home is in a common law or community property state. In common law states, only the deceased spouse’s ownership share of the property receives the basis step-up. If a couple owned the home jointly, this means only one-half of the property’s basis is adjusted to the FMV at death, while the surviving spouse’s half retains its original basis.

In the nine community property states, the rules are more favorable. Upon the death of one spouse, the entire value of the community property, including the surviving spouse’s share, is stepped-up to its fair market value. This “double step-up” can wipe out the entire original gain for tax purposes.

For example, consider a home purchased in a common law state for $200,000 and owned jointly. If it is worth $600,000 when one spouse dies, the new basis becomes $400,000 ($100,000 for the survivor’s original half plus $300,000 for the deceased’s stepped-up half). In a community property state, the new basis for the entire property would be $600,000.

Combining the Rules An Illustrative Example

Consider this scenario in a community property state: A married couple purchased their home 15 years ago for $300,000. At the time of one spouse’s death, the home’s fair market value is $900,000. The surviving spouse sells the home one year later for $950,000.

Because the home is in a community property state, its basis is fully stepped-up to its $900,000 fair market value on the date of death. The capital gain is calculated by subtracting this new basis from the sale price. The $950,000 sale price minus the $900,000 basis results in a capital gain of $50,000.

The Section 121 exclusion is then applied. Since the surviving spouse sold the home within two years of the death, they are eligible for the $500,000 exclusion. As the $50,000 gain is below this threshold, it is excluded from income, and the surviving spouse owes no federal capital gains tax on the sale.