What is the Principal Residence Exclusion?

March 14, 2018

While difficult to believe, many sections of our tax code make things more equitable for American taxpayers. Given its intimidating size and unfamiliar terminology, many assume that it exists solely to create headaches and fund public projects. But crack open the code and engage long enough. You’ll find that authors of the code include quite a few useful opportunities for taxpayers to preserve and grow wealth. The principal residence exclusion is one such provision. Also known as the “primary residence exclusion” or the “personal residence exclusion,” its found in Section 121.  It provides taxpayers with one of the more valuable opportunities for growing wealth through the tax code. 

The principal residence exclusion under Section 121 traces its origin to the Taxpayer Relief Act of 1997. Since then, it has undergone a number of significant changes. In this article, we will discuss the main provisions of Section 121 and highlight some of its more complicated applications. Then, we’ll briefly cover the intersection of Sections 121 and 1031 and point out strategies for using these sections in combination. As we’ll see, this section can be a bit challenging in some of its applications. Accordingly, it’s best to consult with a qualified tax attorney before using 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 two out of the last five year period. These two years spent living in the property need not occur consecutively but must both occur during the most recent five years.

Suppose a taxpayer lives in a property for one year. He or she then chooses to live in another property for three years. Still later, he or she moves back and lives in the original property for an additional year. In that case, the taxpayer can sell the original property at the close of the fifth year and receive the full benefits of Section 121 on this sale. In this hypothetical, the taxpayer is also eligible to use Section 121 if he sells the property used in the intervening three years, as long as all other requirements are met. 

Once Every Two Years

Taxpayers may use this section once every two years. That’s regardless of whether their ownership of property would otherwise allow them to use the section more frequently. In some cases, Section 121 applies even if taxpayers haven’t owned and lived in their property for at least two years. That’s provided they can show “unforeseen circumstances” which led to the sale. That happens when a taxpayer is compelled to relocate for health, personal or employment reasons. In those instances, taxpayers 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. That guarantees that sellers will face the relatively high depreciation recapture rate of 25 percent when they choose to sell. The Housing Assistance Tax Act of 2008, further restricted Section 121. It applies to primary residences converted from use as rental properties. When a taxpayer converts a rental property to a primary residence, only capital gains from periods of “qualifying use” are excludable under section 121. The periods of nonqualifying use are not excludable.  

To better illustrate this point, suppose that a taxpayer owns a rental property for three years. He then converts it into a principal residence, and the taxpayer lives in the property for another three years. Assuming this all occurred after 2008, the taxpayer is only eligible to exclude 3/6 (or one half) of the gain from the sale. That’s because only three of the six 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. That’s done when they exchange their investment or business property for other investment or business property. If a taxpayer converts a principal residence into an investment property, they’re eligible to use Section 121. They then receive the full exclusion as long as the property was used as their principal residence for two out of the last five years. Suppose a person lives in a property for two years, then converts it to a rental for two years. The person then decides to perform a 1031 exchange with it. This person could use Section 121 to take out a portion of the resulting gain tax-free from the exchange. 

If a person lives in only a portion of their investment property, e.g., only one unit in a multi-unit building, that person may exclude only the portion used as a principal residence. The remaining property used for investment purposes is usable in a 1031 exchange. For example, if a person chooses to live in one unit of an eight unit rental complex, they’re eligible to exclude 1/8th of the gain. The remaining proceeds are useable for the replacement property in the 1031 exchange. 

Conversion Into a Primary Residence

If a taxpayer converts his investment property into a primary residence after a 1031 exchange, the taxpayer must own the property following the exchange for a minimum five years. Then, after meeting this minimum holding period, taxpayers must then separate out the nonqualifying use. That’s because the gain attributable to such use will not be excluded under section 121. Suppose a person performs a 1031 exchange and subsequently converts it to a principal residence two years after the exchange. The person then holds it for another five years. That person is only eligible to exclude 5/7 of the gain. Meanwhile, 2/7 would not be excludable, as this would represent the nonqualifying use. 

Our New York City Tax Attorneys Can Help!

As this article makes clear, Section 121, and its principal residence exclusion, is among the most useful tax code provisions.  Unfortunately, navigating this section is not always an easy task. If you’re considering using this tax code section, contact a New York City tax attorney at Mackay, Caswell & Callahan, P.C. We’ll help put you in as favorable a position as possible. 

Image credit: Jeremiah Jarmin 


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