To exclude the gain from the sale of a home from income under IRC Section 121, a taxpayer must have owned and occupied the property as their principal residence for two of the five years immediately preceding the sale. Importantly, the periods of ownership and occupancy do not need to overlap. The law allows for a maximum gain exclusion of $250,000 for single taxpayers or $500,000 for certain married taxpayers. Recently, the IRS has issued proposed regulations to clarify the application of these rules in specific scenarios.
Ownership and Occupancy
- Principal Residence Requirement: A taxpayer must own and occupy the property as their principal residence for two out of the five years before the sale.
- Non-Concurrent Ownership and Occupancy: The periods of ownership and occupancy do not need to be concurrent.
Special Considerations
- Deceased Spouse: A taxpayer is considered to have owned and used a home as a principal residence during the time their deceased spouse used the home as a principal residence. This applies as long as, on the day the home is sold, the taxpayer’s spouse is deceased and the taxpayer has not remarried.
- Divorced Spouses: Divorced spouses can benefit from the ownership and use periods of their former spouses to meet the exclusion requirements.
Gain Recognition
- Non-Residential Use: Taxpayers must recognize gain on any portion of a residential property that is not used for residential purposes.
- Depreciation: Any depreciation allowed on the property after May 6, 1997, triggers recognition of otherwise excludable gain.
Recapture Rule on Depreciation
- Capital Gain Depreciation Recapture: When a residential property that has been depreciated is sold, the portion of the gain attributable to the depreciation is subject to recapture. This means that the gain equivalent to the depreciation taken must be reported as taxable income, even if the overall gain is within the exclusion limits. This recaptured gain is taxed at a maximum rate of 25%.
Exclusion Frequency
- One Exclusion Every Two Years: Generally, a taxpayer can claim only one exclusion every two years.
- Reduced Exclusion: Taxpayers who dispose of more than one residence within two years or who fail to meet the requirements due to specific circumstances, such as a job change or health issues, may qualify for a reduced exclusion amount.