Selling Your Personal Residence
Selling your principal residence and excluding the gain (section 121 exclusion) seems to be pretty straightforward for many people when you think about the two out of five rule. Two out of five rule? Yeah, I'll get to that in a minute. Really though, unless you fall perfectly in those parameters there are several paths to keep you from getting a full exclusion; there are exceptions, it can get messy. Let's get into it.
So First off, “what is this exclusion”? A taxpayer can exclude up to 250,000 single or 500,000 joint from the gain of a principal residence if two tests are met. One of them is ownership and the other is a use test. Ownership means that you have owned the property for at least two out of the last five years ending on the date of sale. Use means you must have been living in that home as a principal residence for at least two out of the last five years - also ending on the date of sale.
These two years can be anywhere within the five-year period so, it does not need to be consecutive. Note: that short or temporary absences will not count against you during that time. Outside of that perfect box there are many possibilities of having issues. First you need to be an eligible taxpayer; you can be ineligible if you are subject to expatriate tax (that’s when you legally renounce your citizenship. Many people use “ex-pat” in casual conversation for those who move to a different country, but true ex-pats no longer have citizenship) or acquired the property through like-kind-exchange during the past five years. Also, if you have taken a gain on a different residence within a two year, then you cannot sell another personal residence with a gain and have the exclusion.
If you are married, to meet the ownership test only one of you needs to qualify, but the use test must be met by both spouses. Before we go on, here are a few places where we can run into other issues and/or exceptions.
Joint owners not married
A home transferred from a spouse
Members of the uniform services or foreign services
Individuals who are physically or mentally disabled
Previous home destroyed or condemned
… just to name a few You may be asking yourself, “well I don't fall entirely into the two out of five years, is there anything that leads to a partial exclusion of gain? The answer is yes there can be a partial exclusion, but they are not very many.
1. A work-related move where you were transferred or took a new job that was farther than 50 miles from the home and the old work location
2. A health-related move where you had to leave to obtain, provide or get treatment, etc. for health-related issues including a doctor recommended change of residence. This can be related to family members generally considered to be the nuclear family (+ the in-law equivalent, really? Yes)
3. An unforeseeable event typically this will be from a death, divorce, or births, but could also include casualty losses.
4. A case-by-case basis whereby the exclusion is based on facts and circumstances, but this is something you would want to have highly documented and may even want to include an IRS private letter ruling.
While we have mentioned or touched on many points regarding the 121 exclusion, there remains one potential larger more complicated issue will arise from a principal residence that has been used in conjunction as the rental property. There are issues from it being a principal residence and then a rental and then slightly different rules if it was a rental first and then turned into a principal residence. This we will cover in a separate article solely dedicated to the topic.