When a homeowner sells their home, under IRC Section 121 a married couple is permitted to exclude $500,000 of gain and a single taxpayer may exclude $250,000. To qualify for this exclusion, the homeowner must have owned and used the property for two of the most recent five years. This exclusion can only be used every two years.
Some taxpayers have pursued a strategy that involves converting appreciated investment property into a primary residence living there for two years and then selling it taking advantage of the IRC Section 121 exclusion.
In 2004, Congress amended Section 121 to limit a taxpayer from converting investment property into their primary residence and then selling it and taking advantage of the exclusion unless the property is held 5 years from the date the property was originally acquired. Certainly, the primary residence exclusion can be used but now there is a waiting period.
Given the increase in the value of properties in certain locations of the Country, it is possible to utilize both the 121 exclusion and a 1031 exchange to the taxpayer’s advantage. If the property has been used two out of the last five years as the taxpayer’s primary residence and at the time of sale, the property is investment property, a combination of both Sections can be used. For example, the taxpayer meets the requirements as stated above. The primary residence was purchased six years ago for $200,000 and now it’s worth $600,000. The single taxpayer lived there for 3 years and during the last 3 years it has been a rental. This taxpayer can take advantage of the Section 121 exclusion of $250,000 and then exchange the rest into another investment property for at least $350,000. This can be a tremendous tax planning tool. A taxpayer should always speak to their tax professional to obtain their advice on these matters.