I recently purchased a new home and have started thinking about long-term investment goals including eventually converting my home into a rental property or even keeping it as a second home. There is another tax strategy that I could take advantage of down the road. Today’s Wealth Building Wednesday discusses the principal residence exclusion which allows homeowners to have a gain on the sale of their primary residence.
Section 121 of the Internal Revenue Code allows homeowners who have resided in their primary residence for at least two of the last five years before selling the property, a $250,000 exclusion from gain for single taxpayers and $500,000 for married taxpayers. This exclusion allows taxpayers to have a gain on the sale of their primary residence up to the maximum limit without having to pay capital gain taxes. Any gain over these exclusion limits is taxable.
Homeowners must reside in the property at least twenty four of the last sixty months prior to selling. The twenty four months do not need to be contiguous but cumulative as the IRS allows you to aggregate your time in order to meet the requirements. For married taxpayers, in order to qualify for the $500,000 exclusion, both spouses must reside in the property for twenty four of the last sixty months otherwise only one spouse may qualify for the exclusion. The exclusion is available once every two years and there is no limit to the number of times you can take it. That said, if you fail to satisfy the requirements, for example due to job change more than 50 miles away, health problems or other unforeseen circumstances, you may qualify for a partial exclusion. Military personnel may be subject to the stop-the- clock clause. What this means is that they may be entitled to a full exclusion regardless of the length of time they resided in their primary residence if they move to satisfy service commitments.
There are other important factors to address when considering a Section 121 exclusion including the following.
- If the property was also used as rental property, you may be eligible for the 121 exclusion and tax deferred treatment. You could complete a 1031 exchange to defer capital gains taxes on the sale and subsequent purchase of property held for business use or for investment purposes;
- If the property was acquired in a 1031 exchange as a replacement property then converted to a primary residence, the property must be owned for at least five years before it qualifies for the primary residence exclusion;
- Under Section 121, you can never exclude depreciation recapture, which is generally taxed at 25%. Any depreciation taken after May 6, 1997 must be recaptured. This applies to periods of time when the property was used as a rental or used for business such as a home office.
- If your home was acquired in a 1031 exchange, rented for a period of time and then converted into a primary residence, you will only qualify for a pro-rated exclusion. You will have to determine the percentage of time the property was held as a primary residence beginning on January 1, 2009 and you will only qualify for that percentage of the exclusion.
Your home is often your most valuable asset. Your CPA can help you determine whether or not you qualify for Section 121 exclusion. 1031 CORP. is always available to discuss 1031 tax deferred exchanges and other tax strategies like the principal residence exclusion.