Section 121 of the Internal Revenue Code (IRC) allows taxpayers to exclude up to $250,000 ($500,000 for married taxpayers filing jointly) of capital gain from the sale of a primary residence if certain conditions are met. The exclusion can be used once every two years.
To qualify for the Section 121 exclusion, the following conditions must be met:
The home must have been owned and used as a primary residence for at least two out of the five years prior to the sale.
The taxpayer must not have claimed the exclusion for the sale of another home within the two-year period ending on the date of the sale.
The taxpayer must meet certain ownership and use requirements.
If the taxpayer meets these conditions, they can exclude up to $250,000 of capital gain from the sale of their primary residence ($500,000 for married taxpayers filing jointly). Capital gain is the difference between the home's basis (typically the purchase price plus any improvements) and the sale price.
The Section 121 exclusion is a valuable tax benefit for homeowners who sell their primary residence. It allows them to exclude a significant amount of capital gain from the sale, which can result in substantial tax savings.
Primary Residence: A primary residence is a home that you own and use as your main home. To qualify for the Section 121 exclusion, you must have owned and used the property as your primary residence for at least two out of the five years prior to the sale. If you meet this requirement, you can exclude up to $250,000 of capital gain from the sale if you're a single filer, or up to $500,000 of capital gain if you're married and filing jointly.
Second Home: A second home is a property that you own but doesn't use as your primary residence. If you sell a second home, you don't qualify for the Section 121 exclusion, but you may be able to reduce your capital gain by deducting certain expenses related to the sale, such as real estate agent commissions and closing costs.
Mixed-Use Property: A mixed-use property is a property that you use for both personal and rental purposes. If you sell a mixed-use property, you may be able to exclude a portion of the capital gain based on the percentage of time that you used the property as your primary residence. For example, if you lived in the property for 50% of the time and rented it out for the other 50% of the time, you may be able to exclude up to 50% of the capital gain.
Rental Property: If you sell a rental property, you don't qualify for the Section 121 exclusion. However, you may be able to defer paying taxes on the capital gain by doing a 1031 exchange, which allows you to reinvest the proceeds from the sale in another rental property without paying capital gains tax.
What if I only rent out one bedroom of my home?
If you rent out one bedroom in your primary residence while you continue to live in the rest of the home, the portion of your property that you rent out would be considered a rental property for tax purposes, while the portion you live in would be considered your primary residence.
When you sell a mixed-use property that includes a rental portion, you may be able to exclude a portion of the capital gain based on the percentage of time that you used the property as your primary residence. In this case, you would need to calculate the percentage of the property that you used as your primary residence (i.e. the percentage of the home that you lived in) and apply that percentage to the gain on the sale of the entire property.
For example, if you lived in 75% of the property and rented out 25%, you may be able to exclude up to 75% of the capital gain from the sale of the property, up to the maximum exclusion amount of $250,000 for single filers or $500,000 for married filing jointly, if you meet the eligibility requirements for the Section 121 exclusion. However, if you have claimed depreciation on the rental portion of the property, you may be subject to recapture rules that require you to pay tax on a portion of the gain.
What if I only rent out my garage?
If you rent out only your garage, the IRS generally considers it as a separate property from your primary residence. Therefore, the rental of your garage would be considered a rental property for tax purposes, while your primary residence would not be affected.
When you sell a mixed-use property that includes a rental portion, you may be able to exclude a portion of the capital gain based on the percentage of time that you used the property as your primary residence. However, in the case of renting out only your garage, you cannot count the garage rental portion as part of your primary residence, as it is not considered part of your primary living space.
In other words, the gain from the sale of your primary residence would be calculated based on the square footage and value of the home itself, not including the garage that is being rented out. If you meet the eligibility requirements for the Section 121 exclusion, you may be able to exclude up to $250,000 of the capital gain from the sale of your primary residence if you are single or up to $500,000 if you are married filing jointly.
What if I live in the house for 2 years & rent for 4 years?
If you lived in the property for 2 years and then rented it out for 4 years, you would have used the property as your primary residence for only 2 out of the 6 years leading up to the sale. This means that you would not meet the ownership and use requirements to qualify for the capital gain exclusion under Section 121.
What if rented the property for 3 years then moved in for 2 years & sold the property?
If you rented the property out for 3 years and then moved in and used it as your primary residence for 2 years before selling it, you would have met both the ownership and use requirements to qualify for the capital gain exclusion under Section 121.
Specifically, you would have owned the property for at least 5 years (3 years as a rental and 2 years as your primary residence) and used it as your primary residence for at least 2 of the 5 years leading up to the sale. This means that you may be able to exclude up to $250,000 of capital gain ($500,000 if married and filing jointly) from the sale of the property.
It is important to note that the exclusion amount is subject to certain limitations and may be reduced if you have claimed the exclusion on the sale of another primary residence within the past two years. Additionally, any gain that exceeds the exclusion amount will be subject to capital gains tax at the applicable rate.
