The great Magical “No Tax Haven 1031” is only for investment or business properties not for personal use, so you can't swap your primary residence for another home. No?! Guess Again! Simply, bypass this with the -121 Exclusion, legitimately and keep your profits from selling your home and jumpstart or grow your investments!
Allright, What Is A 121 Exclusion?
Starting investors usually buy or “use” their first homes for investment purposes, because of the ease to start. A primary residence however still does not qualify for a 1031 Exchange (we dive deep into 1031 here!) as “investment property.” Don’t panic! the IRS created Section 121 to provide a tax savings for people selling their primary residence. This allows for enough tax savings to propel you into your first investment portfolio!
Source: Pure Financial Advisors, Inc.
Section 121 allows an individual to sell her residence and receive a tax exemption on $250,000 of the gain as an individual and $500,000 as a married couple. To be eligible for this tax savings, the home must be held as a primary residence for an aggregate of 2 of the preceding 5 years. This means that you can keep the profits -250K up to 500K – in your pocket and buy into your next investment. It gives you at least an initial tax-free capital opportunity like the 1031 exchange to take that first leap. Warning: Any gain over and above these exclusion limits is taxable.
How A 121 Exclusion Works!
To qualify for the exclusion, you must have lived in the property for a minimum of twenty four months during the last sixty months. That is equal to 2 years in the last 5 years. The twenty four months do not have to be contiguous (next or together in sequence) as the IRS allows you to aggregate (combine, add up) your time living in the house to meet the two year residency requirement. So if you first rented the house for 3 years and then bought it this would also qualify for the 121 exclusion. This opens up a lot of possibilities for renters too! Aren’t you excited? We know we are…😁
Section 121 was effective May 6, 1997 and replaced (1) the old Section 121 which provided a once in a lifetime exclusion of $125,000 if you were over 55 years of age and (2) the old Section 1034 which provided a rollover provision when selling and buying a home of equal or greater value within a two year period.
U.S. Code § 121.Exclusion of gain from sale of principal residence
(a)Exclusion
Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.
The exclusion is available once every two years and there is no limit to the number of times you can take it. When taking the $500,000 exclusion, both spouses must meet the eligibility test and resided in the property for the full 2 years to qualify for the full exclusion. If not, one spouse may only qualify for the exclusion. This could easily be a starters strategy to acquire equity for 2 years in a “live in” investment than selling it for a 121 exclusion and adding the gains to an investment portfolio that will qualify for 1031 exchanges.
You may be eligible for a partial exclusion when failing to meet the two year period because of special conditions, such as a change in health, employment (more than 50 miles away) or other unforeseen circumstances. Members of the military are entitled to full exclusions regardless of the length of time they resided in the property if they move to satisfy service commitments. It is also possible to combine both Section 121 and Section 1031 on a primary residence under specific circumstances. Examples of these circumstances include:
A working farm containing the farmer’s residence—the working farmland falls under Section 1031 and the farmer’s house falls under Section 121.
A duplex or multi-plex with one unit being owner occupied (Section 121), the balance held as investment with tenants (Section 1031).
A residence (Section 121) containing a home office or land that could be partitioned (Section 1031).
Dive Deeper into the Creative Tax Planning World And Take A Closer Look:
3 Major Limitations On A 121 Exclusion
The proposed regulations specify three major limits on a taxpayer’s ability to claim the section 121 exclusion:
Disallowance for use or partial use of the home as a non-residence.
An overall dollar limitation.
The once-every-two-years limitation.
1. Disallowance for use as a nonresidence.
If a taxpayer also uses a home for purposes other than as a principal residence, the gain exclusion does not apply to the extent of depreciation taken on the home after May 6, 1997. However, post-May 6, 1997 depreciation allowable on nonresidential use can trigger gain recognition on the residential-use part of the house.
Example. Jennifer used 25% of her home as an office for a business. She owned and used the home as a principal residence for at least two years during the five-year period before she sold it. The gain exclusion does not apply to 25% of the gain.
2. Overall dollar limitation.
The maximum gain exclusion for an individual taxpayer is $250,000. Taxpayers who jointly own a principal residence, but file separate returns, may each exclude up to $250,000 of the gain attributable to their interest in the home. A husband and wife who file a joint return may exclude up to $500,000 of the gain if:
Either spouse meets the two-year ownership requirement.
Both spouses meet the two-year use requirement.
Neither spouse excluded gain from a prior sale or exchange of a principal residence within the last two years.
Let's Talk Hard Cash (1): Tax Planning Strategy Tip.
If a married couple each own a home before their marriage and one home could be sold at a gain that exceeds $250,000, CPA’s & Tax advisors should recommend to sell the home that would have the smallest gain. The couple can move into the home would have produced a gain higher than $250,000 and live there for at least two years. After 2 years the couple will qualify for the $500,000 exclusion as well!
3. Once-every-two-years limitation.
A taxpayer cannot use the gain exclusion if, during the two-year period after the sale or exchange she sold another home and excluded the gain on that home too. However, there are also other ways where a reduced exclusion may be allowed. Yes, we love exceptions! 😁
Reduced Exclusion Taxpayers who sell their principal residence but don’t meet the ownership and use requirements, or who sell their home within two years of selling another home, may be eligible for a reduced exclusion. The reduced exclusion is available if a change in place of employment, health or unforeseen circumstances necessitated the sale. Neither the Internal Revenue Code nor the proposed regulations define the change in place of employment, health problems or unforeseen circumstances that would allow taxpayers to qualify for the reduced exclusion.
Because the reduced exclusion is calculated by multiplying the exclusion, rather than the gain, by the appropriate fraction, CPAs will find the reduced exclusion provision allows most gains to be fully excluded from income.
Involuntary Conversions Gain from an involuntary conversion (such as destruction, theft, seizure, requisition or condemnation) of a home qualifies for the gain exclusion. In applying the rules of IRC section 1033 (involuntary conversions), the amount realized is reduced by the gain excluded under section 121. If the taxpayer acquires a replacement home, the ownership and use period of the converted home carries over to the replacement home if that home’s basis is determined using the involuntary conversion rules of section 1033(b). Presumably, an involuntary conversion will represent an unforeseen circumstance that allows taxpayers to qualify for a reduced exclusion even if it occurs within two years of another disposition. However, the IRS takes the position that a taxpayer cannot claim an exclusion based on unforeseen circumstances until it issues final regulations or other guidance on the matter.
Pull A Section 121 Exclusion & Keep Your Home!
As an ultimate tax-free wealth growth strategy planning we want to tell you about the possibilities to pull a 121 as an individual, keep ownership of your home and ultimately potentially pulling a 1031 fo’ ever on that same home sweet home!
The key here is to understand that when you contribute property to an entity, the property maintains its tax basis but when you sell a property to an entity, the property receives a stepped-up (new) basis; the selling price.
Let’s talk hard cash (2): Tax Planning Strategy Tip
Isabelle our intelligent investor is married and gets to exclude $500k of capital gains by selling her primary residence (that she fixed for forced appreciation). Isabelle sells the property to her LLC/S-Corporation. So she can pull a 121 and keep ownership of her house via her corporation. The LLC/S-Corporation will have a new basis in the property equal to the fair market value which is the purchase price. Isabelle will report the 500K of capital gains on her own tax returns and pay taxes. Kidding!!! 🤪Due to the section 121 exclusion, the capital gains miraculously disappear. So Isabelle didn’t have to pay taxes and reinvested the 500K as a down payment for bigger investments. Now the LLC/S-Corporation receives a stepped up basis in the property, and when the property is sold, the LLC/S-Corporation will only pay taxes on the capital gains incurred after Isabelle sold it to the LLC/S-Corporation, which is never thanks to the 1031 exchange. We love a happily ever after ending, don’t you?
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