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Navigating the 121 Exclusion: Tax Planning for Real Estate Income

Tax professionals today need to be prepared to incorporate real estate income into their clients’ tax plans. More and more Americans are starting to use their properties as a primary or secondary income source, yet many taxpayers are not prepared for the tax consequences when they decide to sell that property. This is where a trained tax professional can add tremendous value by walking clients through the legitimate tax incentives available to real estate owners.

One of the tax breaks available for homeowners about to sell their property is the “121 exclusion.” Section 121 of the tax code allows single-filing taxpayers to exclude up to $250,000 on the sale of their primary residence (or up to $500,000 for married couples filing jointly). The two main factors in qualifying for this exclusion are ownership and use of the property.

First, the taxpayer must have owned the property and used it as a primary residence for at least 24 out of the last 60 months from the date that the home was sold. These 24 months do not have to be consecutive. So if a taxpayer lived in a house for a year, moved out for a year, and then lived there again for a final year, they could still meet the 24-month requirement.

Because the property must be a residence, if the owner also used that home for business purposes, they will only be able to exclude a portion of the gain on the sale. That portion would depend on the amount of time that the property was used for business. To take the example above, let’s say the taxpayer owned their home for a full three years before selling it, and for the entire year they moved out, the taxpayer rented out the house. That taxpayer would only be eligible for two-thirds of that exclusion amount.

If your client does qualify for the 121 exclusion, that excluded amount will happily not be counted toward net investment income tax (NIIT). NIIT is calculated by adding all income earned from investments and subtracting any relevant expenses. Since the current NIIT rate is 3.8%, that exclusion can result in sizable savings.

Tax planners need to also be aware of the limitations on the 121 exclusion. For instance, if a property owner ends up selling their house at a loss, losses on the sale of a personal residence are unfortunately not deductible, However, if the property is used as a home office or a rental, part of that loss can potentially be attributed to business and become tax deductible.

If the taxpayer owns a second home, that property will not be eligible for the 121 exclusion. An alternative tax savings strategy is to convert the home into a rental property before taking steps toward selling it. The property may then qualify as a business asset, opening up other tax deferral tactics or enabling you to deduct losses on the home. However, the loss on the property would have to occur after it was converted to a rental for that claim to be legitimate.

One of the reasons the 121 exclusion is so popular is that it offers a generous number of exceptions to the rule. If a taxpayer did not meet the requirement of using the home as their personal residence for two out of the last five years, they may still qualify for the exclusion if they fall under one of these five exceptions (covered in § 1.121-1):

  1. Employment: If a taxpayer sells their home because their new job requires them to relocate at least 50 miles farther away from their current residence, they may qualify for a reduced exclusion amount. If the homeowner only lived in the house for one year instead of two, they may still receive 50% of the total—$125,000 for a single filer and $250,000 for the couple filing jointly.
  2. Health: If a family has to move because of a medical diagnosis and needs to relocate in order to treat, care for, or even prevent a specific illness, they may be eligible for this exception.
  3. Unforeseen Circumstances: This is defined as an event that the taxpayer could not have reasonably anticipated that resulted in selling their home. For instance, if a spouse dies and the surviving spouse can no longer afford the home on their own, this would likely qualify.
  4. Non-Specific Events: These are covered with private letter rulings that expand upon the category of “unforeseen circumstances” with specific cases that were approved by the IRS. Successful arguments have involved job-related changes, additional dependents, and environmental factors (see below).
  5. Environmental Factors: One example could be if the home was built on a cliff beside the ocean and over the course of years, natural erosion has etched away at the cliff and made the home dangerous to live in. This can occur in regions like Southern California where homeowners may even be prohibited from staying in the home due to changes in the environment.

A surprising number of arguments can be made under the “unforeseen circumstances.” Another success story occurred with a taxpayer who moved into a new neighborhood and experienced extreme conflict with their neighbor. They were constantly calling the police on each other, and the neighbor set up five camcorders on the fence, all pointing at the newcomer’s yard. This taxpayer certainly couldn’t have predicted the nightmare they were moving into! In this case, the taxpayer was only eligible for a prorated amount, but the exclusion still significantly decreased their tax liability. To receive training on the latest real estate tax provisions and learn how to factor these into your tax planning conversations, apply to become a Certified Tax Planner today.

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