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George F. Bearup, J.D. Senior Legal Trust Advisor

30-Dec-20

IRC 121 – Gain Exclusion on the Sale of a Principal Residence

Take-Away: The Internal Revenue Code provides the exclusion of gains from the sale of a primary home from taxable income. This rule allows married sellers who file joint tax returns to exclude as much as $500,000 and a single filer to exclude up to $250,000 of gains on the sale of a primary residence. While those dollar amounts are what almost everyone remembers, IRC 121’s exclusion of gain on the sale of a principal residence is much more complicated than assumed.

Background: With historically low mortgage interest rates and much of the nation working from home during the pandemic, it is no surprise that in many sections of the country the number of home sales dramatically increased in 2020, along with escalating sales prices to reflect increased demand to live in desirable communities. Most of those individuals who sold their home in 2020 can take comfort from IRC 121 which excludes a fixed dollar amount of capital gains from their taxable income in 2020. A short review of the benefits of IRC 121 is warranted as individuals begin to prepare their 2020 federal income tax returns. It is also important to review some of the ‘lesser-known’ subsections of IRC 121 which can create traps as well as present some tax-savings opportunities.

Basic Rule: IRC 121 exempts capital gain recognition on the sale of an individual’s principal residence, subject to use and ownership conditions and dollar limitations, and is available by making an election, or by opting out of its application. [IRC 121(f).]

  • Used and Owned Conditions: To qualify for this exemption, the residence must have been used as the individual’s primary residence for at least two (2) of the preceding five (5) years, and the individual must have owned the residence for at least two (2) of the preceding five (5) years. In addition, the individual cannot have claimed the IRC 121 exclusion on another home within the 2-year period before the sale of their current primary residence. [IRC 121(a).] Short temporary absences, such as for an extended vacation or for seasonal absences, even if the residence is rented during those temporary absences, will still be ‘counted’ for periods of determining the owner’s
  • Reduced Exclusion: A reduced exclusion is available for an individual who does not satisfy the use and ownership The reduced exclusion applies if the sale of the principal residence is necessitated by a change in place of employment, health, or to any other unforeseen circumstances. The reduced exclusion is computed by multiplying the maximum dollar limitation (either $250,000 or $500,000) by a fraction. The numerator of the fraction is the shortest period of time that the individual owned the residence as his or her principal residence during the 5-year period ending on the date of the residence’s sale. The denominator of the fraction is 730 days or 24 months, depending on whether days or months are used in the numerator. [IRC 121(b)(3)(A); Treasury Regulation 1.121-3(a).]

Example: Roberta purchased her home, used as her principal residence, on October 1, 2019. A year after her purchase of the home, Roberta must sell her home as she lost her job due to the pandemic, but she was fortunate to find a new job, but in a new community. Roberta sells her home on September 30, 2020. Roberta has not previously excluded gain under IRC 121 within the past two years. Roberta is eligible to exclude up to $125,000 of the gain from the sale of her residence: 12 months divided by 24 months times $250,000 = $125,000.

  • Suspension of 5-Year Rule: Upon a timely filed election, the running of the 5-year period with respect to the sale of a residence is suspended during any period that the individual, or such individual’s spouse, is serving on qualified official extended duty as a member of: (i) the uniformed services; (ii) a member of the U.S. Foreign Service; or (iii) an employee of the intelligence community. The 5-year period cannot be extended to more than 10 years. [IRC 121(d)(9).] The 5-year period is extended indefinitely for an individual who is in the Peace Corps. [[IRC 121(d)(12).]
  • Dollar Limitations: An individual owner who meets the used and owned conditions can exclude up to $250,000 gain from his or her income. With regard to married individuals who file jointly, the maximum amount that can be excluded from their taxable income is $500,000, if: (i) either of the spouses meets the ownership requirement; (ii) both spouses meet the use requirement; and (iii) neither spouse is ineligible for the benefits because they availed themselves of the IRC 121 exclusion in the prior two years. [IRC 121 (b)(1)(3).]
  • Surviving Spouses: A surviving spouse may also take advantage of IRC 121 and claim the $500,000 exclusion of gain from income if the sale of his or her principal residence occurs not later than two (2) years after the death of their spouse and the use and ownership conditions were met prior to the spouse’s death. [IRC 121(b)(4).] While the step-up in basis rules under IRC 1014 may eliminate most, or all, of the unrealized appreciation in the residence, the $500,000 exclusion is only available in the year the surviving spouse files a joint return. [Treasury Regulation 1.121-2(b)(3).]
  • Living in a Nursing Home: An incapacitated individual who is incapable of their own self-care, who owns and uses the property as their principal residence for periods aggregating at least one year during the five-year ownership period, will be treated as continuing to use the real property as their principal residence during the five-year period so long as they reside in any facility, including a nursing home, licensed by the state or a political subdivision. [IRC 121(b)(4).]
  • Estates, Trusts, and Heirs: The $250,000 exclusion of gain from income is extended to estates, heirs, and revocable trusts, if the decedent used the property as his or her principal residence for two or more years during the five-year period prior to the sale. If an heir occupies the decedent’s home as his or her principal residence, the decedent’s period of use and ownership can be ‘tacked-on’ to the heir’s subsequent use and ownership when calculating the two-out-of-five-years use and ownership
  • Legal Entities: However, some trusts and other legal entities will not satisfy the ownership If the residence is owned by a family limited partnership or  LLC, the sale by that legal entity will not qualify under IRC 121. A sale of the residence by a marital trust will qualify for the exclusion [Revenue Ruling 85-45]. However,  the exclusion from gain from the sale of a personal residence of the beneficiary of a non-marital trust, e.g. a conventional credit shelter trust, will only be available to the extent that the trust beneficiary possesses the right to withdraw trust corpus. [Private Letter Ruling 200104005 (September 11, 2000.] In that PLR the IRS stated that the husband’s right to occupy all trust property used for residential purposes and also the right to direct the trustee to sell the property and replace it with rent or lease another residence selected by the husband of comparable or lower value, “is not a power to vest the corpus in the husband, nor will the husband be treated as an owner of any additional portion of the corpus of the trust under IRC 678(a)(1).” If the occupant of the trust-owned residence possesses a 5+5 power over the corpus, then 5% of the gain can be excluded.
  • Principal Residence: A principal residence can be a houseboat, a house trailer, or stock held by a tenant-stockholder in a cooperative housing corporation. [Treasury Regulation 1.121-1(b).] However, the sale of tangible personal property held in the residence will not qualify for the IRC 121 exclusion. The IRS will not issue rulings or determinations with regard to whether property qualifies as the individual’s principal residence for purposes of IRC 121. [Revenue Procedure 2000-3.] Nor are the IRC 121 Regulations helpful to determine how much property surrounding the residential structure itself can be excluded on sale under IRC 121.
  • Partial Business Use: If the individual uses a portion of the residence as a home office, workshop, or storage area, the IRS takes the position that the IRC 121 exclusion is not available for that portion of the residence used for business purposes during the qualifying use [Treasury Regulation 1.121-1(e).] It would seem, though, that if the business portion could be severed from the residence, e.g. a workshop unattached to the residence, that the sale of the workshop facility could be covered under IRC 1031, and the rest of the sales proceeds covered under IRC 121.
  • Farms and Duplexes: It is possible to combine the benefits of both IRC 121 and IRC 1031 on a primary residence in narrow circumstances. For example, a working farm that contains the farmer’s residence along with the working farmland might qualify for both: the residence under IRC 121 and the farmland under IRC 1031. Similarly, if a duplex is occupied by the owner as his or her residence, the sale of the residence portion would qualify under IRC 121, while the rental portion of the duplex could qualify under IRC 1031.
  • Partial Interests: An individual can elect to apply the IRC 121 exclusion to the sale of a remainder interest in the individual’s principal residence. [IRC 121(d)(8)(A).] However, other sales of partial interests in the residence, such as a term-of-years or an undivided tenant-in-common percentage interest in the residence, will not be eligible for non-recognition under IRC 121 if sold separately, unless the purchaser is related to the seller as defined in IRC 267(b) or 707(b), i.e. the related family of the individual includes only his or her brothers and sisters, spouses, ancestors, and lineal descendants. [IRC 121(d)(8)(A).]

Conclusion: There was a lot of residential sale activity in 2020 caused by low mortgage interest rates and the ‘work-from-home’ phenomenon. Many will be filing their 2020 income tax returns claiming exclusions under IRC 121. The rules are no all that ‘trickey’ but they require close attention to details. For more information on how IRC 121 is interpreted by the IRS Internal Revenue Service Publication 523.