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

2-Jun-22

Sale of Principal Residence – the IRC 121 Exclusion

Take-Away: The general rule is that the gain on the sale of a principal residence can be excluded from gross income up to $250,000. There is, however, a use condition to this exclusion from gross income that could reduce the amount of the exclusion.

Background: When a homeowner sells their principal residence, some gain can be excluded from their reported gross income. Gross income means all income from whatever source derived. [IRC 61(a).] Gain realized from the sale of property generally is included in an individual’s gross income. [IRC 61(a)(3).] But some gain resulting from the sale of a principal residence can be excluded from the reported gross income.

  • Basic IRC 121 Exclusion: Gain on the sale of real property that is owned and used by an individual as their principal residence for at least two of the five years immediately preceding the sale is excluded from  gross income. [IRC 121(a).] This exclusion is only available once every two years (which limit is in place to prevent abusive tax avoidance.) The two years use need not be consecutive
  • Excluded Amount of Gain: The maximum amount of this exclusion from gross income is $250,000 for a single individual, and $500,000 for a married couple who file a joint income tax return.
  • Unique Circumstances Exclusion: In addition to the basic IRC 121 exclusion from gross income, the gain from the sale or exchange of a principal residence for the primary reason of a (i) change of place of employment; (ii) health; or (iii) unforeseen circumstances, is also excluded from gross income. [IRC 121(c).] This unforeseen circumstances exception is pretty open-ended. [Regulation 1.121-3(e)(1).] They are described as events the individual could not reasonably have anticipated before purchasing and occupying the residence. Safe harbor examples are provided in the Regulations which include involuntary conversions, natural disasters, act of war or terrorism, or a qualified individual’s death, unemployment, divorce, or a multiple births.
  • Calculation of Exclusion: The amount of the exclusion from gross income that can be claimed by the individual is determined by multiplying the maximum amount of the exclusion ($250,000 or $500,000) by the amount of time that the individual has used the property as their principal residence during the preceding five years. [Treasury Regulation 1.121-3(g)(1).] This results in a nonqualified use ratio, which is based on the time allocated to the nonqualified use (the numerator) and the total time of ownership (the denominator) the resulting portion of the gain is not eligible for the exclusion. [IRC 121(b)(5)(B).]

Example: Tom, a single man,  buys a property and uses it as investment real estate for 5 years. Tom then converts the real estate to a primary residence and he lives there for 3 years. At the end of the 8th year of ownership, Tom sells the real property and invokes IRC 121. The nonqualified use ratio would be 5/8th because 5 out of a total of 8 years were used for Tom’s investment purposes. Further assume that Tom’s gain is $700,000 when the sale occurs. Tom can still exclude the maximum allowable amount. Multiplying this amount by 5/8th results in $437,500 of gain that is not excludable as a result of nonqualified use. This means that $262,500 is available for exclusion, which would mean that Tom would be able to exclude the individual maximum amount of $250,000.

The unique circumstances exclusion of the gain is (somewhat) illustrated by the following recentTax Court decision.

Tax Court Case: Webert v Commissioner, Tax Court Memo 2022-32, April 7, 2022

Facts: The Weberts were married in 2004. Mrs. Webert purchased an island home in 2005. That same year she was diagnosed with cancer. Mrs. Webert underwent extensive treatments which led to a long period of financial difficulties for her and her husband. Mrs. Webert and her husband lived in the island home until 2009. Thereafter, the island home was rented out by her, and the couple lived in Mr. Webert’s house. Mrs. Webert’s island home was sold in 2015.

  • The Weberts filed joint income tax returns for the years 2010 through 2015. During those years they reported income from the lease of Mrs. Webert’s island home on Schedule E- “Supplemental Income.” The Weberts also reported that they used Mrs. Webert’s island home for their personal purposes for 14 days in 2010 but no other days in 2011 through 2015. The depreciation schedules that the Weberts attached to their Form 1040 income tax returns for those years mirrored the number of fair rental days that they reported for the island home on their Schedule E’s. On their 2015 Form 1040, the Weberts reported the sale of Mrs. Webert’s island home but they excluded the sales proceeds, or gain,  from their reported gross income.

Tax Assessment: The IRS assessed a federal income tax for the Weberts’ 2015 tax year with regard to the gain on the sale of the island home. The Weberts filed a petition that challenged that assessment in the Tax Court. The IRS then filed a motion for summary judgment in which it claimed that there was no genuine dispute of material fact with regard to whether the Weberts could exclude the gain realized on the sale of Mrs. Webert’s island home from their gross income- they had not lived there in 2 of the past 5 calendar years.

Issues in Dispute: #1: Was there a genuine dispute of material fact that the Weberts did not use the island house as their principal residence for at least 2 of the last 5 years immediately prior to the sale of the island house? #2: Was there a genuine dispute of material fact that Mrs. Webert’s health problems were not the primary reason for the sale of her island home?

Tax Court Decision: With regard to the first issue, the judge found that there was no genuine dispute of material fact that the Weberts did not use the island house as their principal residence for at least 2 of the 5 years immediately preceding the sale of the island house.

As for the second issue, the judge found that there may be genuine dispute of fact that Mrs. Webert’s health problems were the primary reasons for the sale of the island house. Since the Tax Court is required to make factual inferences in the light most favorable to the nonmoving party, i.e. the Weberts, the judge did not feel a summary judgment was warranted, yet. It was not clear if this dispute of fact, i.e. Mrs. Webert’s health condition was the primary reason for the island home’s sale, was material. Consequently, the IRS’ motion for summary judgment was denied at this time.

Conclusion: Most individuals are familiar with the IRC 121 exclusion from gross income and the $250,000 or $500,000 limits. Fewer are familiar with the 2 out of the last 5 year rule, or how even when real property is not used as a principal residence, some gain on its sale can still avoid taxation. Even fewer are aware of some of the other situations where a home is forced to be sold due to unusual circumstances where the 2-out-of-5 year requirement can be avoided.