The principal residence profit exclusion (also called the §121 profit exclusion) is a tax exclusion on profit from a home sale up to a limited dollar amount. Basically, if the homeowner qualifies, they do not have to pay tax on profit resulting from the sale of their primary residence — up to that limited dollar amount.
To qualify for this tax exclusion, a homeowner needs to show they used the property as their principal residence for at least two of the last five years. How does the IRS know that the property sold was the owner’s principal residence and not just some vacation home? Factors the IRS takes into account include:
- the home’s proximity to the homeowner’s place of employment;
- use of the address for the homeowner’s state and federal tax returns; and
- the home’s proximity to banks and other professional services used by the owner. [26 United States Code §§121(a), 121(b)(1)]
Each individual owner is able to exclude up to $250,000 of their profit on the sale of their principal residence. (More on determining the actual amount on Card 4)
Thus, if two homeowners (say, a married couple) own the property, then together they may exclude up to $500,000. However, for both individuals to qualify, both must be owners and meet the two-out-of-five year occupancy rule. If only one homeowner meets the occupancy rule then the profit exclusion is limited to $250,000.
Still, if a married couple do not simultaneously own and occupy the property for at least two of the last five years, they may still qualify for the total exclusion of $500,000 if:
- one of the married individuals owns the residence (since sole ownership by one spouse is imputed to the non-owner spouse);
- both meet the two-out-of-five year occupancy rule;
- they file a joint return for the year of the sale; and
- neither individual has taken a principal residence profit exclusion on another property within two years prior to the sale.
An individual need not occupy the home at the time of sale to qualify for the principal residence profit exclusion.
As long as the homeowner(s) occupied the home for at least two of the last five years, it’s perfectly fine if they sell the home unoccupied or otherwise occupied by a tenant. They still qualify for the exclusion.
However, say the homeowner occupied the home for 23 months out of the last five years. This length of time gets them no grace from the IRS — they do not qualify for the tax exclusion — with one exception.
If the homeowner must relocate due to personal difficulties, then they may still qualify for a partial tax exclusion. Personal difficulties include:
- a change in employment, if the new job is located at least 50 miles away from the owner’s old place of employment (or 50+ miles away from their residence, if they were formerly unemployed);
- a change in health, such as age-related infirmities, emotional issues or even severe allergies; and
- unforeseen circumstances, such as death, divorce or natural disasters.
In this case, if the homeowner had to relocate after occupying the property for 23 months, they may receive an exclusion up to the ceiling amount ($250,000/$500,000) based on the fraction of two year’s time they did occupy the property. Thus:
$250,000 x (23/24) = $239,583
Yes, if an individual homeowner fully qualifies for the principal residence profit exclusion, they qualify for the $250,000 exclusion ($500,000 for taxpayers married, filing jointly).
However, if a homeowner qualifies based on personal difficulties (meaning they relocated before meeting the two-year occupancy requirement), then they don’t qualify for the full exclusion amount of $250,000. Further, the amount excluded on the sale is a percentage of the profit based on the length of occupancy vs. length of ownership, not just the last five years.
Periods of occupancy include:
- the period of ownership prior to January 1, 2009 [IRC §121(b)(4)(5)(C)]; and
- the period the owner used the home as their principal residence after January 1, 2009 and prior to the sale. [26 USC §121(b)(4)(5)(C)(ii)]
For example, an individual homeowner purchased their home on January 1, 2005. They rent it out to tenants until January 1, 2011, when they begin to occupy it as their principal residence. Four years later, the home is sold, closing escrow on January 1, 2015. The total profit on the home sale is $300,000.
Since the homeowner meets the two-out-of-five year occupancy rule, they qualify for the principal residence profit exclusion. The next question is: how much profit can be excluded?
The individual owned the home for ten years. Their total occupancy is eight years (which includes the years 2005-2009, due to the special rule that any period prior to 2009 counts, even if the owner didn’t occupy the home as their principal residence during that time, plus the years 2011-2015 when they did occupy the home as their principal residence). Thus, the ratio is 8:10.
Multiply the ratio by the total profit received on the sale to get the amount the individual may exclude:
$300,000 x (8/10) = $240,000
Thus, the individual excludes $240,000 of their profit from their gross income. (If the amount had exceeded the allowable amount of $250,000 then they would qualify for the maximum of $250,000). [26 USC §121(b)]
Yes. One such exclusion is known as a §1031 transaction. A real estate investor who lived in the property for two of the past five years but does not occupy it at the time of sale may use this exclusion to defer reporting profit on the sale of the property to the replacement property they buy. Part of the vagabond homeownership rules. For more reading on this, see the forthcoming cards on §1031 transactions.
The owner’s expenditures for repairs and replacements that maintain (and often increase) the property’s value are separated into personal or business/investment categories. If personal, such as with the principal residence or a vacation home that is personally used, the homeowner may not write off the expenses to determine their AGI or taxable income.
However, for business operations or investment activities (passive and portfolio income assets), the expenditures for repairs and replacements of maintenance are written off in the year the expenses are incurred as allowable expenses. Thus, though maintenance expenses eliminate the effects of wear, deterioration and functional obsolescence — the very basis for allowing the depreciation deduction — both expenses and depreciation are allowed as tax write-offs and deductions before income is taxed.
As for profits on a sale, a seller’s cost basis for their principal residence is comprised of:
- the price the seller paid for the property when purchased years ago;
- closing costs and settlement fees paid to acquire the home (not including fees paid due to a mortgage); and
- the costs incurred during ownership to renovate and improve the property which add value (improvements with a useful life of more than one year).
These costs are not to be included in the cost basis:
- fire insurance premiums;
- mortgage insurance premiums;
- appraisal fees if required by the lender; and
- any cost already deducted as a moving expense.[26 USC §1012; IRS Publication 523]
Taxwise, the cost basis remaining at the time of resale is deducted from the net sales price to determine whether a profit or loss has been realized by the seller. Whether the profit realized is taxed – recognized – is a separate issue.
For an in-depth explanation of the principal residence profit exclusion, see the first tuesday publication accessible through Realitpedia via your student homepage: Tax Benefits of Ownership, 3rd Ed, Chapter 3: The principal residence profit exclusion.
To read how the principal residence profit exclusion affects California’s homeownership rate, see: Understanding California’s homeownership rate.
For information on the eligibility of the principal residence profit exclusion for homes located outside the U.S., see: U.S. taxpayers’ foreign homes: eligible for residence profit exclusion?
To read about the effect of the Affordable Care Act on capital gains and the principal residence profit exclusion, see: Does the healthcare law really affect sellers of real estate?