Income and Assets · Property, real and personal

Sale of a personal residence

Two orderings decide most § 121 computations and both run against the taxpayer. Depreciation taken since May 1997 comes out of the exclusion first, before anything else is measured. Then gain allocated to periods of nonqualified use is stripped out of what remains. Only what survives both is excluded, and a taxpayer who converted a rental into a home is often left with far less exclusion than the headline figure.

The rule

The exclusion and its two tests. Gross income does not include gain from the sale or exchange of property if, during the 5-year period ending on the date of sale, the property was owned and used by the taxpayer as their principal residence for periods aggregating 2 years or more (IRC § 121(a)). The two tests run independently: they must each be satisfied for two years within the five, but not for the same two years.

The limits. The amount excluded may not exceed a fixed ceiling, doubled on a joint return where either spouse meets the ownership test, both meet the use test, and neither is barred by the frequency rule (IRC § 121(b)(1), (b)(2)(A)); the amounts are in the table below. Where those conditions are not met, the limit is the sum of what each spouse would have had if unmarried, with each treated as owning the property during any period either of them owned it (§ 121(b)(2)(B)) — so one qualifying spouse still produces a full single exclusion.

Once every two years. The exclusion does not apply where, during the 2-year period ending on the date of sale, there was any other sale by the taxpayer to which it applied (IRC § 121(b)(3)).

A surviving spouse keeps the joint figure for two years. An unmarried individual whose spouse is deceased applies the joint limit on a sale not later than 2 years after the date of death, where the joint conditions were met immediately before that date (IRC § 121(b)(4)).

Failing the tests does not always mean losing the exclusion. Where the sale is by reason of a change in place of employment, health, or unforeseen circumstances, the ownership, use and frequency requirements are switched off and the dollar limit is prorated instead — by the shorter of the qualifying period or the time since the last excluded sale, over two years (IRC § 121(c)(1), (2)). The regulation supplies safe harbours that are deemed unforeseen: involuntary conversion; natural or man-made disaster; and, for a qualified individual, death, divorce or legal separation, multiple births from a single pregnancy, cessation of employment leaving them eligible for unemployment compensation, and a change in employment leaving them unable to pay housing and reasonable basic living expenses (Treas. Reg. § 1.121-3(e)(2)).

Depreciation is carved out first. The exclusion does not apply to gain up to the depreciation adjustments, as defined in § 1250(b)(3), attributable to periods after 6 May 1997 (IRC § 121(d)(6)). That gain is unrecaptured section 1250 gain and carries its own rate.

Then nonqualified use is allocated out. The exclusion does not apply to gain allocated to periods of nonqualified use, allocated on the ratio of aggregate nonqualified use during ownership to the whole period of ownership (IRC § 121(b)(5)(A), (B)). Nonqualified use means any period the property is not the principal residence of the taxpayer or their spouse or former spouse, other than periods before 1 January 2009 (§ 121(b)(5)(C)(i)). And the ordering is explicit: § 121(b)(5)(A) is applied after § 121(d)(6), and the allocation in (B) is computed without regard to the depreciation gain (§ 121(b)(5)(D)).

Three periods are not nonqualified use. Any portion of the five-year period after the last date of use as a principal residence; up to an aggregate 10 years of qualified official extended duty; and up to an aggregate 2 years of temporary absence for a change of employment, health, or unforeseen circumstances (IRC § 121(b)(5)(C)(ii)(I)–(III)). The first is the important one: moving out and renting the house before selling it does not create nonqualified use, but renting it before moving in does.

Divorce. A transferee under § 1041(a) tacks the transferor’s ownership period, and an individual is treated as using the property as a principal residence during any period of ownership while a spouse or former spouse is granted its use under a divorce or separation instrument (IRC § 121(d)(3)(A), (B)).

Extended duty suspends the clock. At the individual’s election, the five-year period is suspended while they or their spouse serve on qualified official extended duty in the uniformed services, Foreign Service or intelligence community — a duty station at least 50 miles from the property, or Government quarters under orders — but by no more than 10 years (IRC § 121(d)(9)(A), (B), (C)(i)).

Property from a like-kind exchange is barred for five years. Where the property was acquired in an exchange on which gain was not recognised under § 1031(a) or (b), the exclusion does not apply to a sale during the 5-year period beginning on acquisition — and the bar follows anyone taking a carryover basis (IRC § 121(d)(10)).

Current figures

How it works in practice

Compute in the order the statute sets. Start with total gain. Subtract the post-May-1997 depreciation as gain that cannot be excluded under § 121(d)(6). Take what is left and split it between qualified and nonqualified use on the ownership-period ratio in § 121(b)(5)(B) — computed, as (D)(ii) directs, without regard to the depreciation gain. Only the qualified-use portion is eligible, and it is then capped by the dollar limit.

The direction of the conversion decides everything. A house lived in and then rented before sale generates no nonqualified use, because § 121(b)(5)(C)(ii)(I) excludes any part of the five-year period after the last date of principal residence use. A house rented and then moved into generates nonqualified use for the whole rental period from 2009 forward. Identical properties, identical years, very different answers.

Where the two-year tests fail, do not stop. Section 121(c) is a proration, not a denial, and the safe harbours in Reg. § 1.121-3(e)(2) are broader than most clients expect — a job loss with unemployment eligibility is a listed safe harbour, not an argument that has to be made.

How this has changed

The nonqualified use rule was added prospectively and its start date is still doing work. Periods before 1 January 2009 are outside the definition (IRC § 121(b)(5)(C)(i)), so for a property held since the 1990s a substantial rental history may generate no allocation at all. Any worked example that allocates across the whole ownership period without checking the 2009 line will overstate the taxable portion.

The depreciation carve-out has a date of its own — 6 May 1997, the effective date of the modern § 121 (IRC § 121(d)(6)). Depreciation before that date is not carved out, which matters for a rental converted in the mid-1990s and still held.

Section 121(d)(11) was repealed in 2010 by Pub. L. 111-312 § 301(a), and the paragraph number is now vacant in the statute. Citations to § 121(d)(11) point at nothing; the like-kind exchange bar is § 121(d)(10).

The reduced exclusion moved from a discretionary standard to a list. Section 121(c)(2)(B) refers to unforeseen circumstances “to the extent provided in regulations”, and Treas. Reg. § 1.121-3(e)(2) supplies specific-event safe harbours that are deemed to qualify. Where a safe harbour applies there is no facts and circumstances argument to make, and where none does, § 1.121-3(e)(1) still allows the general test — but expressly not where the primary reason is a preference for a different residence or an improvement in financial circumstances.

Exam focus

Expect the conversion direction to be the whole question. Rental first then residence produces nonqualified use; residence first then rental does not.

Expect the ordering with both depreciation and nonqualified use in the facts. Depreciation first, then allocate the remainder.

Expect a failed two-year test with a sympathetic reason, testing whether you know § 121(c) prorates rather than denies, and whether the reason is one of the regulation’s safe harbours.

Expect a joint return where only one spouse qualifies. The answer is the single-filer amount, not nothing.

Check yourself

1. A single taxpayer owned and lived in a home for three of the last five years and sells at a 400,000-dollar gain, with no depreciation and no nonqualified use. How much is excluded?

Answer: 250,000 dollars, the limit in IRC § 121(b)(1). The ownership and use tests in § 121(a) are met, and the remaining 150,000 dollars is long-term capital gain.

2. A married couple file jointly. Both have lived in the home for three years but only one owns it. What is the limit?

Answer: 500,000 dollars. IRC § 121(b)(2)(A) requires only that either spouse meet the ownership test, while both must meet the use test.

3. A home was rented from 2010 to 2018 and used as a principal residence from 2018 until sale in 2026. What fraction of the gain is allocated to nonqualified use?

Answer: Eight of the sixteen ownership years, so one half, under IRC § 121(b)(5)(B) — all eight rental years fall after 1 January 2009 and so count under § 121(b)(5)(C)(i).

4. The same property produced 40,000 dollars of depreciation after May 1997. Is that included in the allocation?

Answer: No. IRC § 121(b)(5)(D) applies § 121(d)(6) first, so the 40,000 dollars is excluded from the exclusion at the outset, and the nonqualified use ratio is then applied to the remaining gain without regard to it.

5. A taxpayer acquired a house in a § 1031 exchange three years ago and has lived in it for two of those years. May the exclusion be claimed on a sale now?

Answer: No. IRC § 121(d)(10) denies the exclusion for the 5-year period beginning on the date the property was acquired in an exchange on which gain was not recognised under § 1031(a) or (b), regardless of the ownership and use tests being met.