Many landlords become accidental landlords by moving out of and then renting out their primary residences. Others take a more deliberate approach, being that they intend to purchase a property as a primary residence, live it in for a year or two, and then move out and rent it. And then there is another group of landlords who house hack their way to financial freedom.
Whichever group you fall into, understanding your future selling implications will either make or cost you a lot of money. I’m talking about the Section 121 Exclusion, also known as the “Capital Gains Exclusion” and the “two out of five years” rule.
It can be a complicated rule depending on your personal situation. So, true to my writing style, we’re going to dive into the depths of this rule and try to drum up situations applicable to each one of you reading this article.
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The “Section 121” Rule
The rule stems from Section 121 of the IRS tax code, which is why it’s often referenced as the “Section 121” rule. Essentially, the rule stipulates that if you own and use a property as your principal residence for two of the previous five years and then you sell the property, you may be able to qualify for a $250k capital gain exclusion.
If you’re single, you only qualify for a $250k exemption. But if you’re married, you can claim your $250k exemption, and your spouse can claim their $250k exemption for a total $500k exemption! If you are able to shelter $500k of long-term capital gains, you’ll save around $75k in taxes alone.
What if only one of you owns the property or even brought the property into your marriage? Doesn’t matter. If you are filing a joint return in the year of the sale and one of the spouses meets the ownership and use tests, you will be eligible for a $500k capital gain exclusion.
You can only use the exclusion once every two years, but there is no limit as to how many times you use the exclusion throughout your lifetime. A savvy investor working with a great CPA can add significant wealth in a relatively short amount of time.
It should be noted that the exclusion only qualifies for the capital gain portion of your total gain, and it will not shelter your depreciation recapture.
Defining the Various Parts of the Rule
As with any IRS rule, every word really comes with its own subset of definitions. So let’s go ahead and explain what “two years,” “own,” “use,” and “principal residence” mean in the IRS’s eyes.
The IRS requires that you own and use the property as a principal residence for a period of two years. Two years may be satisfied by “establishing ownership and use for 24 full months or for 730 days (365 × 2).” Additionally, the two-year period does not have to be concurrent as long as the two-year period in which you owned and used the property falls within a five-year timeframe.
Ownership is defined as it normally would be under any other circumstances — mainly that you have legal ownership of the property. Better yet, the property can be owned by a trust or single member disregarded entity, and as long as you own the trust or entity, the property can still qualify for the exclusion.
Use is defined as the period of physical occupancy. You are allowed to take short vacations and sometimes even seasonal occupancy is allowed.
A principal residence is defined as that in which you primarily use as your main home. Indications of a primary residence include your mailing address, your place of employment, locations of clubs and organizations you are affiliated with, location of your banks, and the address listed on your federal and state tax returns, driver’s license, voter registration card, and personal property registration.
If you have a primary home and a vacation home and alternate between the two, the property that is used a majority of the time during the year ordinarily will be considered your principal residence.
What if You Are House Hacking?
House hacking is a great way to build wealth, break into real estate, and live relatively for free. However, it comes with its own set of tax consequences.
You must allocate the property between your principal and business use. The Section 121 exclusion will apply only to the portion of the home you personally occupied. For instance, if you own a four unit, occupy one and rent the other three units out, when it’s time to sell the property, you will only be able to qualify 25% for Section 121 purposes. The remaining 75% (the business use portion) will be subject to regular capital gain taxation.
Fun fact: If you are house hacking a single family home, you can indeed qualify the entire home for Section 121 purposes. Per the IRS code, “No allocation is required if both the residential and non-residential portions of the property are within the same dwelling unit.”
This allocation requirement often surprises my clients who are house hacking a multifamily property — and for good reason. The tax liability incurred often requires a look at alternative deferment solutions, such as a 1031 exchange.
How is Basis Determine When You Move Out?
There is a rule that stipulates when you move out of a primary residence and convert it into a rental, the basis for the rental will be the lower of your adjusted basis or fair market value (FMV). So if you have a large gain and decide to convert your property to a rental, you may find it surprising that you can’t use the FMV at the time of conversion and basically hide all of your gains, as this gentleman found out.
Your adjusted basis is essentially your purchase price, plus costs of improvements. The FMV will be determined by an appraisal or comps.
There is confusion as to why this rule exists. Why can’t you simply write up the basis of the property to the FMV when you convert it to a rental? Because the IRS wants their fair share of the profits resulting from your solid investment abilities.
But if you look at it on the flip side, it actually protects us as taxpayers from folks who make poor investment decisions. For instance, if someone had bought at the peak of the market in 2008 and suffered a huge loss, without this rule, they would be able to convert to a rental and maintain their original basis. This would allow the taxpayer to then sell the property and write off the loss as a net operating loss, which would indirectly affect all of us as taxpayers.
Let’s illustrate this concept:
Pete buys a home in 2008 for $400,000. In 2009, it’s worth only $100,000. Pete is a not a good investor. Pete is reading the IRS code and realizes that if he converts it to a rental, he may be able to take a $300,000 loss on his taxes. However, the rule “lesser of FMV or adjusted basis” prevents Pete from writing off the loss because at the time of conversion, the FMV ($100,000) is less than his adjusted basis ($400,000), so he can’t realize the loss. The basis of his rental is now $100,000.
Timing Move Out and Sale Dates
Now that we understand how to figure the basis when you move out of your primary residence, it will be important to keep the timing rules of the Section 121 exclusion in mind.
If you move out of the property, you have been living in for the past two years and convert it to a rental, you essentially have three years to sell the property until your exclusion runs out. For instance, you bought in January 2010 and moved out in January 2012, you have until January 2015 to sell the property and still qualify for the Section 121 exclusion.
It also doesn’t matter how long you lived in the property prior to converting it to a rental because the Section 121 exclusion is only a five-year window. So you can live in a property for 30 years, but when you convert it to a rental, you have three years to sell it if you still want the exclusion. In hot markets, such as last year and this year, utilizing the Section 121 exclusion may be a great idea if you can swing it.
One last note about timing your move out. Oftentimes, I will see the question posed in the forums: “Can I move out sooner than two years and still qualify?” Yes, but highly unlikely. At a high level, you must incur an unforeseen circumstance that requires you to move away or makes it no longer feasible for you to stay in your home. Most excuses don’t qualify.
Can You Move Into a Rental and Use the Exclusion?
Say you bought a rental, then later decided you wanted to move into it for two years to avoid capital gain taxes upon sale. Can this be done?
Unfortunately, no. You must pro-rate the gain between the rental use prior to moving in and the principal residence use.
As an example:
Say Pete had rented a property for four years (2010, 2011, 2012, and 2013) and then used it as a primary residence for two years (2014 and 2015) to qualify for the capital gains exclusion by selling it in the next year. If he has a capital gain of $150,000, it will be allocated between these periods of rental and personal use. Since there are only two years of personal use out of a total of six years the property is held, only one third of the gain ($50,000) is deemed qualifying for the Section 121 exclusion.
Add Section 121 to Your Investment Strategy
So there you have it. If this wasn’t a part of your investment strategy, it should be now. We broke down the rule into its various parts, talked about moving out and calculating basis, house hacking, and even moving into a rental. While it may seem complicated, just remember “two out of five years,” and you’ll be fine!
Investors: Have any questions about this exclusion?
Let me know with a comment!