What is the Principal Residence Exclusion?
As challenging as it may be to believe, many sections of our tax code are designed to make things more equitable and fair for American taxpayers. Given its intimidating size and foreign terminology, many people assume that the tax code exists solely for the purpose of creating headaches and collecting funds for public use. But if you have the inclination to crack open the tax code and can stay engaged long enough, you’ll ultimately find that authors of the code included quite a few useful opportunities for taxpayers to preserve and grow their wealth. The principal residence exclusion, also commonly known as the “primary residence exclusion” or the “personal residence exclusion,” under Section 121 provides taxpayers with one of the more valuable opportunities for growing wealth through the tax code.
The principal residence exclusion available under Section 121 traces its origin to the Taxpayer Relief Act of 1997 and has undergone a number of significant changes since its inception. In this article, we will discuss the main provisions of Section 121 and highlight some of its more complicated applications. Then, we will briefly cover the intersection of Section 121 and Section 1031 and point out the strategies for using these sections in combination. As we’ll see, this section can be a bit challenging in some of its applications, and so it’s best to consult with a qualified tax attorney before attempting to use this section in conjunction with your sale.
Principal Residence Exclusion Basics
Taxpayers are eligible to exclude up to $250,000 of gain from the sale of their “principal residence” when they invoke the principal residence exclusion under Section 121. Married couples filing jointly are eligible to exclude up to $500,000. To qualify as one’s “principal residence,” the taxpayer must live in the property as their primary dwelling for at least 2 out of the last 5 year period. These two years spent living in the property need not occur consecutively but must both occur during the most recent 5 years. So, for instance, suppose a taxpayer lives in a property for 1 year and then chooses to live in another property for 3 years, and then moves back and lives in the original property for an additional year. In that case, the taxpayer would be eligible to sell the original property at the close of the 5th year and then receive the full benefits of Section 121 on this sale. In this hypothetical scenario, the taxpayer would also be eligible to use Section 121 if he sold the property used in the intervening 3 years, as long as all other requirements were met.
Taxpayers may use this section once every 2 years, regardless of whether their ownership of property would otherwise allow them to use the section more frequently. In some cases, taxpayers may be able to use Section 121 even if they haven’t owned and lived in their property for at least 2 years provided they can show “unforeseen circumstances” which led to the sale. So, for example, if a taxpayer is compelled to relocate for health, personal or employment reasons, then that taxpayer may be able to utilize Section 121 even with a short holding period.
In order to promote fairer taxation, Congress and the IRS have put various restrictions on the availability of Section 121. Taxpayers are not eligible to use the exclusion for any gain attributable to depreciation, guaranteeing that sellers will face the relatively high depreciation recapture rate of 25 percent when they choose to sell. Also, with the Housing Assistance Tax Act of 2008, Section 121 was further restricted as it applies to primary residences converted from use as rental properties. When a taxpayer converts a rental property to a primary residence, only those capital gains derived from periods of “qualifying use” may be excluded under section 121, while periods of nonqualifying use are not excludable.
To better illustrate this point, suppose that a taxpayer owns a rental property for 3 years and then converts that rental property to a principal residence, and then lives in the property for another 3 years. Assuming this all occurred after 2008, this taxpayer would only be eligible to exclude 3/6 (or one half) of the gain from the sale, because only 3 of the 6 years count as periods of qualifying use. So if this person had a gain of $200,000, only $100,000 would be excludable.
Application of Sections 121 & 1031 to the Principal Residence Exclusion
The applicability of Section 121 gets trickier when properties used in a 1031 exchange become involved. There are additional rules and guidelines which pertain to sales of this kind. As we’ve pointed out, Section 1031 allows taxpayers to defer recognition of capital gains when they exchange their investment or business property for other investment or business property. If a taxpayer converts their principal residence into an investment property, then they are eligible to use Section 121 and receive the full exclusion as long as the property was used as their principal residence for two out of the last five years. So if a person lives in their property for two years, then converts this property to a rental for two years, and then decides to perform a 1031 exchange with this property, this person could use section 121 to take out a portion of the gain tax-free from the exchange.
If a person lives in only a portion of their investment property – say only one unit in a multi-unit rental complex – then that person may exclude only the portion of their property used as a principal residence, while the remaining property used for investment purposes may be used in a 1031 exchange. For example, if a person chooses to live in one unit of an eight unit rental complex, then they would be eligible to exclude 1/8th of the gain, while the remaining proceeds could be used toward the replacement property in the 1031 exchange.
If a taxpayer decides to convert an investment property to a primary residence after performing a 1031 exchange, then the taxpayer must own the property following the exchange for at minimum five years. Then, after this minimum holding period is met, taxpayers must then separate out the nonqualifying use, as the gain attributable to such use will not be excluded under section 121. If a person performs a 1031 exchange and then subsequently converts the property to a principal residence two years after the exchange and then holds it for another five years, then this person would only be eligible to exclude 5/7 of the gain, while 2/7 would not be excludable, as this would represent the nonqualifying use.
As this article makes clear, Section 121, and the principal residence exclusion contained within it, is undoubtedly among the most useful provisions found in the tax code. Unfortunately, navigating this section is not always an easy task. If you are considering use of this section of the tax code in the near future, you should contact a New York tax attorney at Mackay, Caswell & Callahan, P.C. so you can be sure you’re putting yourself in as favorable a position as possible.
Image credit: Jeremiah Jarmin