Reducing your taxes, Section 121 Exclusion and the accidental landlord

Many accidental landlords become landlords when they move out of their primary residence and as a result rent it out. Others are more intentional and purchase homes as their primary residence with the goal to live in it for a couple years, move out, and then rent it. Whichever group you fall into, there are major implications that could either make you or cost a lot of money. Let's talk about the Section 121 Exclusion, the “capital gains exclusion” also known as the “2 out of 5 years” rule.

The Section 121 Exclusion derives from the IRS tax code and allows homeowners to be exempt of capital gains when selling their primary home, up to $250k if filing Single and $500k if filing Married. If you’re able to take advantage of the full $500k exemption, you’ll be saving roughly $75k in capital gains taxes when you sell your home.

What is capital gains? Simply, a tax imposed when individuals part with an asset and make a net profit on it.

An example:

John and Sally have owned their home for 5 years. They bought their home January 1, 2014 for $500,000. In 2019, they have just closed on the sale of their home for $1,000,000. Their net gain would be $500,000, entirely tax free.

Of course, this is a simple example, as you’d normally need to factor in closing costs and commissions as well.

What are the requirements for the exclusion?

“2 out of the last 5 years” rule

You(and your spouse if married) must live on the property for 2 out of the last 5 years prior to claim the full exclusion. Ownership and occupancy does not have to be concurrent. You could move in for 1 year and also 1 year on the 5th year. You could also live at the home for 30 years and then convert it to a rental. However, remember you have only 3 years after the sale to sell the home and still qualify for the exclusion as qualification applies only to the previous 5 years at the time of sale.

Can I move out earlier than 2 years after purchasing a home and still qualify for the exclusion? Yes, but highly unlikely. If you fail to satisfy the requirements due to job change or health problems, reduced exclusions are available.

There is no lifetime limit to how many exclusions you can claim, however, you can claim this exclusion only once every 2 years. Many investors take advantage of this by purchasing and selling after 2+ years. Rinse and repeat.

House hacking vs owner occupied multi-family

Some investors who “house hack” buy single family homes with the intention to live in one bedroom and rent out the others. Then there are investors who purchase a 2-4 unit multi-family home and live in one unit and rent out the others. Both scenarios have varying degrees of qualification for the 121 Exclusion.

For the owner occupied multi-family, you must allocate between personal use and business use. Section 121 only applies to the part of the home that you personally use.

Example:

If you purchase a 4-plex for $500,000 and live in one unit while renting out the other 3, sell after 2 years for $700,000, you only qualify for 25% of the capital gains exclusion after the sale of the property because only ¼ of it was “primary residence”. Only 25% of the $200,000 capital gains would be exempt.

For house hackers, per the tax code, “No allocation is required if both the residential and non-residential portions of the property are within the same dwelling unit.” Provided you do not take depreciation during the qualification period, you can indeed qualify the entire home for Section 121 purposes. It should be noted that the exclusion only applies to the capital gains and does not shelter the depreciation recapture.

Can you move into a rental and claim the Section 121 exclusion?

Let’s say you want to move into a rental you bought years ago to avoid paying capitals gains via the Section 121 exclusion. Can this be done?

The answer is No. You must prorate the capital gains between the time the home was a rental and when it was primary residence. A provision contained within the Housing and Economic Recovery Act of 2008 amended Section 121 of the Internal Revenue Code to essentially eliminate this method for qualifying for the exclusion. Luckily, you can use the section 1031 exchange to defer the gains on the business allocated portion. Using the Section 121 exclusion and Section 1031 exchange in conjunction can be a powerful tool for an investor. I will cover the Section 1031 exchange at a later time.

Example:

You purchase a home and rent it out between 2013 - 2016. Then you decide to move in for 2 years to complete the “2 out of 5 years” . On the 6th year, you sell the home. You must allocate the capital gains between rental and personal use, therefore, you’d be on the hook for ⅓ (2 out of the 6 years) of the capital gains upon sale of the property and the remaining portion would be exempt.

Summary

These are some of the basic requirements you must meet to qualify for the exclusion. If this wasn’t part of your investment strategy, it should be now! And as difficult as it may seem, just remember the “2 out of 5 years” rule and you’ll be fine!

As a reminder, using a combination of tax strategies at the right time is a powerful way to build wealth.

For more detailed requirements and combinations with other tax strategies, I’d suggest obtaining professional financial advice as laws and requirements are always evolving. I give credit to much of this information to Bill Exeter at Exeter1031.com (I have no affiliation to this company).

Disclaimer: I am not an accountant or expert in the US tax code. Any information within this website is for informational purposes only and is not a substitute for obtaining accounting, tax, or financial advice from a professional. Online readers of this information are encouraged to seek out professional advice prior to performing any actions based on the information provided in this article.

Have any questions about the article? Visit me at my website https://edwardseid.com/or http://facebook.com/seidrealestate