Journal of Financial Planning: October 2024
As a senior financial planner with Apella Wealth (https://apellawealth.com/), Claire Thornton, CFP®, EA, works with women experiencing formative life transitions including the loss of a partner, navigating windfalls, and planning growing careers and families. Claire earned her Master of Science in taxation from Golden Gate University.
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When it comes to financial planning, it is not uncommon for the primary residence to be a client’s largest asset. As such, planners are likely rather familiar with the general rules under IRC § 121, which allow for homeowners to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains at disposition. Today, we set out to dive to a level deeper in our understanding of IRC § 121 in the pursuit of better understanding the nuances and complexities that arise in a client’s life and the subsequent impact it may have on this powerful tax benefit.
History of IRC § 121
Before we discuss scenarios surrounding the IRC § 121 exclusion, it’s interesting to note how this code section came into being. Only 73 years ago, there was no capital gain exclusion whatsoever. It was not until Congress passed the Revenue Act of 1951 that some capital gain relief was granted for taxpayers. This came in the form of gain deferral under IRC § 112; so long as a taxpayer purchased a replacement primary residence of equal or greater value, the gain would not be recognized upon the sale of the prior residence. The downside to this benefit is that the taxpayer then carried the burden of tracking the deferred gain. IRC § 112 eventually was redesignated to IRC § 1034 (this was later repealed in 1997 and should not be confused with “cousin” code sections 1031 and 1033).
In 1964, Congress took the preferential tax treatment of primary residences a step further by enacting a version of IRC § 121 focused on benefiting older Americans. In its original form, IRC § 121 allowed for the maximum capital gain exclusion of $125,000 at the sale or exchange of a residence so long as the taxpayer was 55 years or older and used the house as their primary residence for at least three of the last five years. This was a one-time allowance, meaning if the taxpayer did not use the full capital gain exclusion on the sale of a property, the excess was lost forever.
In 1997, IRC § 121 was expanded into the version we know today; so long as a taxpayer uses the property as their primary residence in the past two out of five years, they benefit from the $250,000/$500,000 exclusion amounts outlined earlier. Unlike its original form where the benefit was only available one time, taxpayers today can use this exclusion every two years if the eligibility requirements are met.
Understanding Eligibility
How is eligibility defined? It is a two-pronged test of ownership and use. A taxpayer must be an owner of the house for at least 730 days (24 full months). For a married couple, only one spouse is required as owner for both to qualify. As far as the use test, the 730-day use period does not have to be consecutive, however unlike ownership, both married individuals must meet the use requirement to benefit from the full $500,000 exclusion.
It is also important to highlight who or what qualifies as a taxpayer for ownership purposes. Equitable ownership is not true ownership as demonstrated in Frank Macboyle Lewis Testamentary Trust B v. Commissioner. In this case, the home was titled in a bypass trust and the surviving spouse used it as their residence. When they went to sell the property, the survivor was disqualified from any capital gain exclusion because the irrevocable trust was the owner and thus not a qualified taxpayer. It is also important to note, as ruled in Farah v. Commissioner, a partnership that owns a principal residence also does not qualify as a taxpayer for capital gain exclusion purposes. As made clear in these cases, it is critical to guide clients through effective estate planning and asset titling.
Planning Considerations
Section 121 and divorce. As any planner knows, complexity often arises at the crux of personal relationships and finances. As such, it is important to review the complexity of IRC § 121 in divorce settlements. Under IRC § 1041, no gain or loss is recognized incident to divorce. As a result, a spouse who receives real estate during settlement has transferred basis even if they bought their former spouse out of the property. The time that the former spouse owned the residence carries over for ownership test purposes, however time of use cannot be tacked on. In other words, the receiving spouse cannot step into the former spouse’s shoes for use-test purposes. To add another layer to the interplay between IRC § 121 and divorce settlements, there are unique rules related to divorced spouses who are co-owners of a property. This is most often seen when the custodial parent receives a court order to stay in the home until a child reaches age 18. This allows for a unique benefit to the spouse who no longer lives in the home but who is still a joint owner; they can tack on the custodial parent’s period of use to benefit from future gain exclusion. For divorcing homeowners who have not yet met the two-year ownership and use tests, it may be worthwhile for the divorce decree to require that one spouse remain in the home until the two-year requirement is met as both taxpayers can benefit from their $250,000 share of the exclusion.
Income-earning property. In instances where the primary residence takes on another purpose—like the addition of an at-home office or conversion into a rental—the application of the full capital gain exclusion is still possible. In a situation where a taxpayer has a home office used exclusively for business within the same dwelling, the entire residence still qualifies for the exclusion. However, the definition of a single structure is key here; a detached garage, basement, guest house, any portion of the home with a separate entrance, or any detached structure do not qualify under the definition of a single structure and therefore would not be included in the IRC § 121 exclusion. As far as converting a primary residence into a rental, a taxpayer may do so and still benefit from the exclusion so long as it is sold within three years of the conversion. For clients interested in selling a property in the near-term while still allowing for passive income, this three-year conversion timeline offers the best of both worlds.
Improvements to the home. Another common situation homeowners often navigate is remodeling. How far down to the studs can you take a remodel while still qualifying for the exclusion? A version of this question is answered for us in Gates v. Commissioner. The Gates family used a home as their principal residence having satisfied both the ownership and use requirements of IRC § 121. They then underwent a major home remodel that, due to complications and building code, resulted in a full teardown and rebuild on the same land. Without having fulfilled the ownership and use requirements of their rebuilt home, the Gates family sold the property. They took the $500,000 capital gain exclusion, and the IRS subsequently disallowed it. The Gates family argued that the land was the primary residence, not the dwelling. The tax court ultimately sided with the IRS, stating that the property was the dwelling and the rebuild effectively reset the clock. This is an interesting fact pattern and subsequent decision given the fact that IRC § 121 does not specify in these terms. The court’s decision goes on to pose another scenario that may garner a different result; what if a taxpayer tears down a dwelling, but keeps the foundation? Where does a remodel end and a rebuild really begin? This theoretical further highlights the delicate balance in effective implementation of IRC § 121.
Offsetting losses. Through all its complexities, IRC § 121 does lend the taxpayer one major level of flexibility and simplicity: opting out. A taxpayer may choose to elect out of the gain exclusion by simply including the gain from the sale of a principal residence on the tax return; there is no additional form to file. It may make sense to elect out if a taxpayer has a large capital loss to offset the subsequent sale or the gain is relatively small, and the taxpayer expects to sell another primary residence with a higher imbedded gain within the 24-month window.
Conclusion
Like many aspects of financial planning, the concept of IRC § 121 is simple but its application may be far from straightforward. What sort of IRC § 121 intricacies have you experienced or are currently solving for with your clients? We’d love to hear from you in the Financial Planning Association All Member Forum!1
Endnote
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