Welcome back. So far we've looked at two major non-taxable exchanges; like-kind exchanges and involuntary conversions. Recall that under these rules, taxpayers could differ or postpone realized gains such that the realized gain would be different from the recognized gain. In this video, let's talk about a third non-taxable exchange. Interestingly, in this non-taxable exchange, we'll see that we will not have a postpone gain but rather an excluded gain. That is the realized gain will never be recognized under the tax rules. So to begin, recall that if the sale of a personal use asset generates a realized loss, the loss is actually not recognized. For example, if I sell my personal home at a loss or my personal car at a loss or my personal furniture at a loss, I cannot deduct that loss at all on my personal tax return. However, on the gain side as a general rule, realized gains on personal use assets, including our principal residence, must be recognized. Again, if I sell my personal vehicle at a gain, I must recognize the gain. If I sell my personal furniture a gain, I must recognize that gain. However, there is a very valuable provision in the Internal Revenue Code, Section 121 that states that the realized gain on the sale of a principal residence, so my personal home or apartment, can be partly or wholly excluded from income recognition. Let's look at this provision a little more closely. Specifically section 121 states, the taxpayers may exclude the first $250,000 of gain on the sale of a personal residence. To qualify, the rule say that the taxpayer must own and use the property as a principal residence for at least two years during the five-year period ending on the date of the sale. Note that the residents does not have to be owned and used, for example, in the two most recent years of the five-year period. It could be that the taxpayer owns and uses the property for two years, then lives somewhere else for one or two or three years and then sells that first property. That's still okay under section 121. So up to $250,000 in gain on the sale of the property will be excluded from income. Now, for tax payers that are married and filing a joint tax return, the exclusion is higher in that the first $500,000 of gain is excluded. But to qualify, first, either spouse must meet the at least two your ownership test. Second, both spouses must meet the at least two-year use requirements. Third, neither spouse cannot be ineligible for the exclusion because, for example, maybe one of the spouses sold a principal residents within the prior two years and already claimed his or her share of the Section 121 exclusion. As with many tax rules, there are exceptions to the own and use time period that's typically required for gain exclusion under section 121. In other word, s the taxpayer or taxpayers might not have to meet the two-year tests but they can still potentially exclude gain on the sale of their personal residence. Such exceptions include a change in the place of employment, but the distance test as it pertains to the moving expense deduction must be met as we saw many videos ago. In particular, the location of the taxpayers new job must be 50 miles further from the old home than the old home was from the old job. Another exception deals with the physicians recommendation for a change of residence or there is an involuntary conversion like a fire. Another exception deals with the death of a qualified individual or a divorce or legal separation. There are other exceptions as well, including if you or your spouse had multiple births from a single pregnancy like having twins or triplets or more. However, even with these exceptions, the full amount of the exclusion may not be available. The amount of exclusion is prorated in terms of the number of qualifying months over the two year or 24 month test period. Here, you would take the share of the 24 months that the taxpayer actually owned and used the property and multiply it by the applicable exclusion limit or $250,000 if not married filing jointly, so single and maybe head of household for example, or $500,000 if married filing jointly. Some other points here. The amount realized is calculated as the selling price of the personal residence minus selling expenses such as advertisements commissions and legal fees. Repairs and maintenance, for example, painting the walls or cleaning the carpets and the house that the seller does to help sell the property is not a selling expense and it does not add to the taxpayer's basis in the residence. So you would compare the amount realized to the basis of the house to determine the realized gain or loss. A second point here is that the purchase of a replacement resonance is not required to qualify for section 121. Recall that with our other non-taxable exchanges with like-kind exchanges and involuntary conversions, we had to make sure we met the replacement property rules. Here, no replacement property is required. You can sell your house and move into a tent or onto a boat and still qualify for the section 121 exclusion. Third, the basis in the new residence is simply the cost of the new residence. The basis is not adjusted based on how much gain was excluded. We would only adjust basis to reflect a postpone gained as we did with like-kind exchanges and involuntary conversions. We do not have to do that here. Fourth, the section 121 exclusion is not automatic but you can elect to forgo the exclusion. You'd probably elect to forgo if you believe you'll sell another property within the next two years, perhaps a property that has a bigger gain and that could use up more of the exclusion. Finally, any realized gain attributable to depreciation is not eligible for section 121 exclusion treatment. For example, if you had a home office and depreciated it, which then reduce the basis of your home to the extent realized gain is there because you depreciated your home office, that has gained represented by depreciation is actually not excluded under section 121. So let's take a look at a few examples to illustrate how the section 121 exclusion works. First, we have Mary who is single and 35 years old. She sells her principal residence that she purchased four years ago and realizes a $230,000 gain. How much of the gain can Mary exclude? Here's section 121 allows an exclusion of gains of up to $250,000 for non married filing joint filers as long as they own and use the property as their principal residence for at least two of the last five years. In this case, Mary is single and she has owned and used the property for four of the last five years. Therefore, she can exclude her entire $230,000 gain under section 121. Now, what if Mary's realized gain is $320,000, how much gain can she exclude now? Again, she can exclude only the first $250,000 of gain under Section 121 because she's not married filing jointly. The remaining $70,000 of gain is actually a longterm capital gain and will be taxed at preferential rates. Now, what if Mary is married to Paul and they have owned and occupied the residence for the last four years, and there's the $320,000 gain. How much of this gain can be excluded? In this case because Mary and Paul are married filing jointly, section 121 allows an exclusion of gains up to $500,000 assuming at least one spouse owned the residents and both spouses used the residence for two of the last five years and that neither spouse is ineligible to claim the section 121 exclusion. In our second example, Holly has lived in her first house in Los Angeles for six months with her husband Wood when they get a divorce, get it? Hollywood? Holly's sells the house and moves to New York. How much may Holly exclude and gain from the sale of a primary residence? Here, Holly owned and used the house for only six of the last 24 months. Also at the end of the year, they're divorced, so not married filing jointly. Divorce is an exception to the two year ownership and use test but she can only exclude the gain up to the prorated share of qualified time over the two years that she owned and used the home. Therefore, Holly may exclude six twenty-fourths or one quarter of the $250,000 limit. That is the non married filing joint exclusion or she can exclude $62,500. Again, this exclusion will be at partial is still out because it's a result of a divorce. In our final example, we have Krista, whose owned and use the house as a principal residence for the last 17 years. She marries Josh in January, 20x2. Josh sold his residence where he lived for six years in October, 20x1 and realized a $145,000 gain. Krista sells her residence in December 20x2 and realizes a gain of $378,000. First, what is Josh's recognized gain related to the sale of his home? Well, notice here that Josh was single at the time he sold his home in October 20x1. So what implications does this have? So this means that Joshs' section 121 limit is $250,000, not the $500,000 limit reserved for married filing joint taxpayers. But that's okay here. His gain of a $145,000 happens to be less than the $250,000 limit. So his entire gain is excluded. He does not have to recognize any gain on the sale of his home. Now, what is Kristas' recognized gain related to the sale of her home? Well, she sold her home in December 20x2, which is 11 months after getting married to Josh in January 20x2. But recall that Josh just used his section 121 exclusion in October 20x1. In order to qualify for the $500,000 exclusion for Mary taxpayers, either spouse must meet the two-year ownership tests and here Krista qualifies since she owned the home for the last 17 years. Both spouses must meet the two-year use test, and neither spouse cannot be ineligible to claim the section 121 exclusion. Here, we have a problem. Here, Josh does not meet the two-year use tests and Josh used his section 121 exclusion in October 20x1. So although Mary realize a gain of $378,000, she can only exclude the first $250,000. The remaining $128,000 would be taxed as a long-term capital gain tax at preferential rates. So that's an unwelcome tax bill to Mary. Could you suggest a better tax strategy to Krista and Josh? Well, from a strictly tax perspective, a better strategy would be for Krista and Josh to live in the house for another year so Josh meets the two-year use tests and becomes eligible to claim section 121 again. If this happens, they can have up to $500,000 in gain to be excluded while Josh can still keep the exclusion he claimed on the sale of his home. So in summary, section 121 provides taxpayers with an outright exclusion of gains on the sale of a personal residence. In particular the first $250,000 of realized gain will not be recognized, and that exclusion limit goes up to $500,000 if taxpayers are married filing jointly. To qualify, the taxpayer must own and use the property as a primary residence for two of the last five years. While for married filing joint taxpayers, at least one spouse must own the property and both spouses must use the property for two of the last five years, and neither spouse can be ineligible to claim the section 121 exclusion because one or both of them claimed it within the last two years.
