Selling Your Principal Residence: IRC 121, Tax Implications and OBBBA Updates

What qualifies as your principal residence?

Whether a property qualifies as your residence depends on how you actually use it and the surrounding facts and circumstances. A house, condominium, cooperative apartment, mobile home, or houseboat may qualify. Having somewhere to eat, sleep, and use the bathroom does not, by itself, establish that the property is your principal residence.

Section 121 qualifications

The principal rule associated with selling your personal residence is Section 121. It allows an eligible taxpayer to exclude up to $250,000 of gain, including taxpayers filing single or married separately, or up to $500,000 for qualifying married couples filing jointly.

Ownership: You generally must own the home for at least two years during the five-year period ending on the sale date.

Use: You generally must use the property as your principal residence for at least two years during that same five-year period. The periods do not need to be consecutive, and ownership and use do not have to occur at exactly the same time.

One exclusion every two years: Generally, you cannot claim the full exclusion if you excluded gain on another home sale during the two-year period ending on the current sale date. A reduced exclusion may be available under the exceptions discussed below.

Note: Property acquired through a Section 1031 exchange generally is ineligible for the Section 121 exclusion if sold during the five-year period beginning with its acquisition.

Note: For the full $500,000 joint exclusion, either spouse must meet the ownership test, both spouses must meet the use test, and neither spouse may be disqualified by the prior-sale limitation.

Note: A taxpayer who becomes physically or mentally unable to care for themselves may count qualifying time in a state-licensed care facility toward the use test. The taxpayer must have owned and used the home as a principal residence for at least one year during the five-year period and continue owning it during the qualifying facility stay. This does not eliminate the two-year ownership requirement.

Have multiple properties? Which one is your primary?

Under Treasury Regulation Section 1.121-1(b)(2), the determination depends on all the facts and circumstances. If you alternate between two residences, the one you use for most of the year ordinarily is your principal residence. Relevant factors include:

1. Your place of employment.
2. The principal home of your family members.
3. Addresses on tax returns, your driver’s license, automobile registration, and voter registration.
4. Your mailing address for bills and correspondence.
5. The location of your banks.
6. Religious organizations and recreational clubs with which you are affiliated.

Other evidence, such as children’s schools, business interests, and records showing where you actually spend your time, may also be relevant. No single address or document settles the issue on its own.

Nonqualified use when excluding gains under IRC 121

When claiming a Section 121 exclusion, it is important to review any nonqualified use that may prevent part of the gain from being excluded. This generally includes periods after December 31, 2008, when neither you nor your spouse or former spouse used the property as a principal residence, subject to exceptions.

One important exception generally covers the part of the five-year lookback period after the last date the home was used as a principal residence. Renting a home after moving out can therefore have a different result from renting it before moving in. Certain temporary absences and qualifying official extended duty can also receive special treatment.

Depreciation allowed or allowable after May 6, 1997, remains ineligible for exclusion, even when a period of rental use falls within an exception to nonqualified use.

Relevant court cases and rulings

Bentley v. Department of Revenue, Oregon: The taxpayers moved from Oregon to Washington in 2009 but retained connections to Oregon, including a home, driver’s licenses, banking, and a voting connection. They operated their Washington business until it closed in 2014 and later returned to Oregon. The court held that they were not Oregon residents for the 2011 tax year because the evidence supported a change in domicile.

This was a state-domicile case, rather than a federal Section 121 decision. It illustrates why keeping connections to one state does not necessarily establish that you still live there.

Can you qualify for a reduced exclusion?

Under Treasury Regulation Section 1.121-3, a reduced maximum exclusion may be available when the primary reason for selling is a change in place of employment, health, or unforeseen circumstances, even if you do not satisfy the normal ownership, use, or prior-sale requirements. See Herbert v. Commissioner.

Unforeseen-circumstance safe harbors include qualifying events involving death, unemployment, divorce or legal separation, multiple births from the same pregnancy, involuntary conversion, and certain natural or man-made disasters. The specific requirements still need to be met.

PLR 201628002: A married couple owned a two-bedroom condominium where their child’s bedroom also served as a home office and guest room. An unexpected additional child contributed to the need to move, and the IRS approved a reduced exclusion based on the particular circumstances.

This does not mean every unexpected pregnancy automatically qualifies. A private letter ruling applies only to the taxpayers who requested it and cannot be cited as precedent by others.

Involuntary conversions

Under IRC Section 1033, gain from an involuntary conversion may be deferred if the applicable requirements are met and sufficient proceeds are reinvested in qualifying replacement property. This is a deferral of tax, rather than a permanent exclusion.

The replacement period generally ends two years after the end of the first tax year in which gain is realized. Exceptions apply, including generally four years for a principal residence destroyed in a federally declared disaster. Section 121 may first exclude qualifying gain, with Section 1033 potentially deferring the remaining gain.

The amount reinvested, type of replacement property, and applicable deadline should all be reviewed before assuming the entire gain can be deferred.

Home office: How does it impact the sale?

If a home office is within the living area of your home, you generally do not need to allocate a separate portion of the sale to that office or report that portion separately on Form 4797 solely because of the office use.

However, gain attributable to depreciation allowed or allowable for periods after May 6, 1997, cannot be excluded. For typical straight-line building depreciation, that amount generally is unrecaptured Section 1250 gain, subject to a maximum 25% federal rate, rather than automatically ordinary income. Other depreciated assets can have different treatment.

Separate business or rental space, such as another unit in a multifamily property, a detached business structure, or a retail storefront, generally requires a separate allocation. Whether that portion qualifies for exclusion depends on whether it independently satisfies the applicable ownership and residence-use requirements.

Basis: Calculating your gain

Calculating the adjusted basis of your property is necessary to accurately assess the gain and potential tax due.

Gain = Selling price − Selling expenses − Adjusted basis

Home improvements are often the largest additions to the original basis. Examples include additions such as a garage or extra bedroom or bathroom; patios, fences, walkways, driveways, and swimming pools; and qualifying HVAC, plumbing, filtration, roof, and other improvements.

Routine repairs generally do not increase basis unless they are part of a qualifying larger improvement project. Keep invoices, receipts, and records of the work completed.

Note: Basis must also reflect applicable reductions, including depreciation allowed or allowable and qualifying energy-related credits or subsidies associated with improvements included in basis.

Post-OBBBA updates

The OBBBA did not increase the $250,000/$500,000 Section 121 exclusion or change the basic two-out-of-five-year ownership and use tests.

One related change is the termination of the Section 25C energy efficient home improvement credit and Section 25D residential clean energy credit after 2025, subject to their specific timing rules. Previously allowed credits can still affect the adjusted basis used when you eventually sell the property.

Planning before you sell

For more information on selling your property, please schedule a call with our office for a consult.