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Real Estate Tax Savings: The 121 Exclusion—How to Qualify (Even if You are an Exception to the Rule)

More and more Americans are starting to use real estate as a primary or secondary income source. From renting out a space as an Airbnb to renovating a second home for rent or sale, taxpayers may already have unrecognized opportunities to earn extra cash from their properties. However, many taxpayers are not prepared for the tax consequences when they decide to sell that property. This is where connecting with a Certified Tax Planner can help.

One of the tax breaks available for homeowners is known as 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 you also use your home for business purposes, you will only be able to exclude a portion of your profits on that 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 home would only be eligible for two-thirds of that exclusion amount.

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

What limitations are there for the 121 exclusion? The first is if you end up selling your home at a loss.Unfortunately, losses on the sale of a personal residence are not deductible. However, if your property is used as a home office or a rental, part of that loss can potentially be attributed to business and become tax deductible.

Additionally, if you own a second home, that property will not be eligible for the 121 exclusion. An alternative tax savings strategy is to convert the second home into a rental property before taking steps toward selling it. The property may then qualify as a business asset, which could open up other avenues for deducting losses or deferring taxes. However, the loss on the property would have to occur after it was converted to a rental for that strategy to work.

An important footnote to the 121 exclusion is that there are a surprising number of exceptions to the rule for this tax benefit. If a taxpayer does not meet the two out of five years requirement, they may still qualify for the exclusion if they fall under one of these five exceptions:

  1. Employment: If you sell your home because your new job requires you to relocate at least 50 miles farther away from your current residence, you may be able to qualify for a reduced exclusion amount. Even if you only lived in the house for one year instead of two, you could be eligible for 50% of the total—$125,000 for a single filer and $250,000 for the couple filing jointly.
  2. Health: If your family has to move because of a medical diagnosis and you need to relocate in order to treat, care for, or even prevent a specific illness, you 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, or letters from the IRS responding to specific cases made by taxpayers in the past. These rulings help expand what may fall under the “unforeseen circumstances” category. Successful arguments have involved job-related changes, additional dependents, and environmental factors (see below).
  5. Environmental Factors: Say a home was built on a cliff beside the ocean, and over the course of years, natural erosion 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 by law from living in the home due to changes in the environment.

A surprising number of arguments can be made under “unforeseen circumstances,” in particular. One success story happened 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 even set up five camcorders on their fence, all pointing at the newcomer’s yard. The taxpayer in this case certainly couldn’t have predicted the nightmare they were moving into! Though the IRS only approved a prorated amount because of the short length of stay in the home, this still significantly decreased the taxpayer’s tax bill. For expert guidance in determining if you qualify for the 121 exclusion, connect with a Certified Tax Planner today.

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