Two weeks ago I finished the Certified Financial Planner introductory course to personal taxes and learned about a very attractive benefit of home ownership: Internal Revenue Code Section 121. Sec 121 allows the gain on the sale of a residential home to be excluded from income. The exclusion is up to $250,000 for a single person or up to $500,000 for a married couple filing jointly.
That’s a lot of money that can be excluded from taxes. However, there are some caveats if the residence was used as a rental since 2008. Yes, I know these concepts might bore some, but I was deeply intrigued. As a California native I’ve seen the housing market do amazing things. One day I may get to give someone the good news that they get $250k/$500k of income tax free. Or I may even get to benefit from it myself. The specific requirements to qualify for Sec 121 are below.
Singles Taxpayers can exclude up to $250,000 in capital gains IF
- Taxpayer used residence as principal one for 2 of the past 5 years, and
- Taxpayer has not used Section 121 within the past two years.
Married Taxpayers filing Jointly can exclude up to $500,000 in capital gains IF
- One of the spouse’s owned the home for 2 of the past 5 years,
- Both must have lived in it for 2 of the past 5 years, and
- Neither spouse can have used Section 121 within the past two years.
- If only one of the spouses meets the ownership or use criteria, then he or she can exclude up to $250,000 in capital gain
- A widow(er) can exclude up to the full $500,000 if the residence is sold within two years after death of spouse and the other requirements are met. The widow(er) must be unmarried.
Exceptions (because every IRS Code needs a little color)
- If Taxpayer moves out for unforeseen circumstances (employment changes, natural disaster, divorce, etc) then the ownership and use criteria can be prorated. For example, if a single taxpayer had to leave 12 months after buying and living in the residence, then he or she would get to deduct 50% of Section 121 up to $125,000
- Gains above Sec 121 limit will be treated as long term capital gains
Both of the caveats for depreciation and rentals are only if the property was ever rented out for income or used as part of a trade or business. If you see yourself potentially benefiting from this generous income exclusion you would be well served to consult with a tax professional. In addition to my notes above you can also find the actual regulation on the IRS website.
Is home ownership for you? There’s no right or wrong answer
Personally, I’ve rarely considered home ownership attractive. I’m too young and mobile to want to settle down in a specific location. Plus my income has not allowed it. But who knows, if I move to a less expensive area than SoCal (and what area isn’t??) I may decide to settle down for 2+ years in order to benefit from Section 121.
My reasoning reminds me of the time I proposed to my ex-boyfriend so he could qualify for my employer’s generous health benefits. Fortunately for both of us, he declined the offer. Somehow I have been gifted with the ability to make things some dream about (like home ownership or marriage) into a practical utilitarian transaction. Although my emphasis on practicality may be too much for some, it’s always good to keep in mind repercussions of major financial decisions; especially when there’s a potential tax benefit to be had.