The increasing prices of the housing market in recent years have led to larger-than-ever gains on the sale of a taxpayer’s home, leading to taxpayers owing substantial amounts to the IRS as a result. Section 121 or a home sale gain exclusion can provide a significant tax benefit for any taxpayer who sells their primary residence.

What Is the Home Sale Gain Exclusion Under Section 121?

The home sale gain exclusion (section 121) is a tax benefit that allows a taxpayer who sells their primary residence to choose to exclude up to $250,000 of the gain or up to $500,000 if they are married, filing jointly. However, section 121 contains many requirements and exceptions that most common taxpayers may not realize.

How does it work?

Section 121 has many tests that a taxpayer must pass to qualify. The taxpayer must have owned the home (ownership test) and used the home for (use test) at least 2 years within 5 years, ending on the date of the sale or exchange of the home. When referring to the “use” of a home, it refers to use as the taxpayer’s principal residence. A principal residence can be determined by multiple factors; for instance, if a taxpayer has multiple homes they live in, whichever home the taxpayer uses the majority of the year would count as a principal residence. However, there are other factors that a taxpayer must consider: the address where the taxpayer receives bills and correspondence, or has listed on the taxpayer’s voter registration card; the taxpayer’s federal and state tax returns; the taxpayer’s driver’s license; and the taxpayer’s car registration. Luckily, when deciding these factors or in seeing whether a taxpayer passes both tests, the 2-year requirement does not need to be the same 2 years for both tests; both just need to be within the 5 years, and if the taxpayer is married, then only one spouse must meet the ownership test.

Understanding the Partial Exclusion of Gain

Some taxpayers may not meet the requirements for the full home sale gain exclusion because of circumstances causing them to relocate from their home in less than two years after purchase. As a result, in certain situations, a partial exclusion can still be available. A partial exclusion can be attained if there was a change in employment location, a health factor, or unforeseen circumstances. A change in employment location requires the taxpayer to have taken or transferred to a new job in a work location that is at least 50 miles farther from the home than the old work location of the taxpayer. If the taxpayer did not previously have a job and therefore did not have an old work location, then as long as the taxpayer began a new job that is at least 50 miles from their home, then they can still qualify. A health factor requires that the taxpayer move in order to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of an illness, injury, or disease of the taxpayer or a taxpayer’s family member. Also, if a doctor recommended a change in residence because the taxpayer is experiencing a health problem, however, the treating or creating a benefit to general health or well-being will not qualify; one of the above-mentioned reasons must be the reason for the doctor’s recommendation. Lastly, an unforeseen circumstance can be caused by the destruction or condemnation of the home, a casualty loss suffered from a natural or man-made disaster, or an act of terrorism, if anyone who called the home their residence died, or became divorced or legally separated. Furthermore, any event that occurred that IRS has determined to be an unforeseeable event can apply.

How is it calculated?

A partial exclusion can be calculated by multiplying the exclusion amount by the fraction of the period owned over 24 months or 730 days. The period owned can be expressed using days or months, whichever is the shortest of the two for the fraction. An example of this calculation would be if a taxpayer uses the home for 15 months after the purchase of the home and sells the home due to a health factor. The calculation would then be (15/24*250,000).

Why Section 121 Matters More Than Ever?

Section 121 is important to know because the rising prices within the housing market are creating a substantial increase in gains from sales of homes, creating realizable taxable gains when taxpayers sell their principal residence. Furthermore, the section 121 exclusion has remained static, remaining at the same amount since 1997, and has not accounted for inflation or for the housing boom during and post Covid-19. As a result, taxpayers must consult professionals to become informed about other methods or ways they can reduce the gain generated from the sale of their home, or what methods can be taken to offset the increase in tax liability they may have the year of the sale of their home.

Contact Us Today

With home sale gains continuing to rise, understanding how Section 121 applies to your situation can help you avoid unexpected tax liability, so call us at 203-489-0612 to discuss how to maximize available exclusions and plan ahead before selling your home.

Written by: Tyler Goncalves