Tax break for owners occupying a rental has changed

Real Estate Tax Talk

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Q. I bought a rental home three years go and have been renting it out ever since. If I move into the home now and live in it for two years and then sell it, will I qualify for the full $250,000 home-sale exclusion?

A. No. The maximum Section 121 exclusion you’ll qualify for is $100,000 (40 percent of the full $250,000 exclusion for single taxpayers).

One of the greatest boons in the tax code for the average person is the Section 121 home-sale exclusion. Homeowners who qualify for it don’t have to pay any income tax on up to $250,000 of the gain from the sale if they’re single, or up to $500,000 if they’re married filing jointly.

Qualifying for the Section 121 exclusion is simple: You just have use the home as your principal residence for at least two years of the prior five years before it’s sold.

As Section 121 was originally enacted in the 1990s, this meant that you could buy a house, rent it out for three years, live in it for two years, and then sell it and qualify for the entire Section 121 exclusion. Thus, you could avoid having to pay tax on up to $500,000 of otherwise taxable gain. And you could do this over and over again. However, those days are gone.

Section 121 was amended in 2008. For sales and exchanges after Dec. 31, 2008, gain from the sale or exchange of a principal residence allocated to periods of nonqualified use is not excluded from gross income. Nonqualified use means any period in 2009 or later where neither you nor your spouse (or your former spouse) used the property as a main home.

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Example: You purchased a home on Jan. 1, 2009, and rented it out until Jan. 1, 2012, when you moved in and made it your main residence. You sell the home on Jan. 1, 2014 for a $100,000 gain. During the five years you owned the home there were three years of nonqualified use. Because three of five is 60 percent, only 40 percent of the $100,000 gain can be excluded under Section 121.

However, nonqualified use does not include any portion of the five-year period in the two-out-of-five-year Section 121 exclusion that falls after the home is used as the principal residence of the taxpayer or spouse. In other words, if you live in the home and then rent it out, the periods of rental use after you lived in the home aren’t a nonqualified use and your Section 121 exclusion won’t be affected.

Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.


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