Section 121 of the Internal Revenue Code Explained
Learn the tax principles governing the sale of a primary residence and how they allow homeowners to shield profit from capital gains tax.
Section 121 of the Internal Revenue Code provides a tax benefit to homeowners when they sell their main property. This provision allows individuals to exclude a portion of the profit, or gain, from their taxable income. The core idea is to alleviate the tax burden associated with the appreciation of a primary residence. This tax relief is not automatic and requires satisfying specific criteria laid out by the IRS.
Core Eligibility Requirements
To qualify for the home sale exclusion, a taxpayer must satisfy two primary tests related to the five-year period ending on the date of the sale: the ownership test and the use test. The ownership test requires that you have owned the home for at least two years during this five-year window. This ownership does not need to be a single, uninterrupted block of time.
The use test mandates that you must have lived in the home as your main residence for at least two of the five years before the sale. Similar to the ownership test, these two years do not have to be continuous. The 24 months of residency can be accumulated in separate periods. The IRS defines a main home based on facts and circumstances, considering factors like your address on tax returns, driver’s license, and voter registration.
A third condition, the look-back rule, prevents taxpayers from using this exclusion frequently. You are ineligible to claim the exclusion if you have already excluded the gain from the sale of another home within the two-year period prior to the current sale. This rule ensures the benefit is applied to the sale of a principal residence over a reasonable period, rather than being used for sequential short-term property sales.
Calculating the Exclusion Amount
The amount of gain you can exclude from your income depends on your filing status. For single or individual filers, Section 121 allows for an exclusion of up to $250,000 of the gain from the sale. If an eligible individual sells their main home and realizes a gain of $300,000, the first $250,000 would be excluded, and only the remaining $50,000 would be subject to capital gains tax.
For married couples filing a joint tax return, the exclusion amount doubles to $500,000. To qualify for this higher exclusion, specific conditions must be met. While only one spouse needs to meet the two-year ownership test, both spouses must meet the two-year use test. Additionally, neither spouse can have used the home sale exclusion for another property within the two-year period before the current sale date.
If a married couple files separately, each spouse may be able to claim an exclusion of up to $250,000. For each spouse to claim their own exclusion, they must each meet the ownership and use tests for the property independently. This scenario provides flexibility depending on the couple’s specific situation.
Determining Your Taxable Gain
Before you can apply the exclusion, you must first calculate the total gain on the sale of your home. The formula is the selling price minus your adjusted basis in the property. The selling price is the gross price reduced by any selling expenses. These deductible expenses include:
- Real estate broker’s commissions
- Advertising costs
- Legal fees paid for the sale
- Seller-paid closing costs like title insurance
The adjusted basis represents your total investment in the home for tax purposes, and it starts with the original purchase price. This initial basis is then increased by the cost of capital improvements, which are projects that add value to the home or prolong its life. Examples include adding a new room, renovating a kitchen, replacing the roof, or installing a new HVAC system.
Conversely, certain events can decrease your basis. If you used a portion of your home for business or as a rental property and claimed depreciation deductions, those amounts reduce your basis. Any insurance reimbursements you received for casualty losses or government subsidies for home improvements can also lower your basis.
Reduced Exclusion for Special Circumstances
Homeowners who sell their property before meeting the two-year ownership and use requirements may still be eligible for a partial exclusion. This relief is available if the primary reason for the sale is a change in workplace location, a health-related issue, or another unforeseen circumstance as defined by the IRS.
To qualify for a reduced exclusion due to a change in employment, the new job location must be at least 50 miles farther from the home than the old job location was. For health-related moves, the sale must be primarily to obtain, provide, or facilitate medical care for the homeowner or a family member. The IRS also provides a list of specific “safe harbors” for unforeseen circumstances, including:
- Death, divorce, or legal separation
- Destruction of the home
- The birth of multiple children from a single pregnancy
- Becoming eligible for unemployment
- A change in employment that leaves you unable to pay your mortgage and basic living expenses
The amount of the reduced exclusion is calculated on a prorated basis. You determine the portion of the two-year requirement you did meet and apply that fraction to the full exclusion amount ($250,000 or $500,000). For instance, if a single filer lived in their home for 12 months before selling for a qualifying reason, they met half of the two-year requirement and could exclude up to $125,000 of their gain.
Reporting the Home Sale
The requirement to report a home sale to the IRS depends on whether you have a taxable gain and if you received a Form 1099-S, Proceeds From Real Estate Transactions. If your entire gain is covered by the Section 121 exclusion and you did not receive a Form 1099-S, you do not need to report the sale on your tax return.
You must report the sale if you have a gain that exceeds your maximum exclusion amount. Reporting is also mandatory if you received a Form 1099-S, which is issued by the closing agent in a real estate transaction. Even if you have no taxable gain, the issuance of this form triggers a reporting requirement to show the IRS why the proceeds are not taxable.
When reporting is necessary, the sale is detailed on Form 8949, Sales and Other Dispositions of Capital Assets. The information from Form 8949 then flows to Schedule D (Form 1040), Capital Gains and Losses. On Form 8949, you will report the gross proceeds, your adjusted basis, and subtract the amount of your excluded gain.