The Section 121 exclusion is a great tax benefit for homeowners. It allows them to exclude taxes on gains up to a certain amount if they meet the Section 121 criteria. That’s nice for homeowners, but what if the home is within an estate? Does the home still get the exclusion?
What is the Section 121 Exclusion?
The Section 121 exclusion states that if a person has lived in their primary residence for 2 out of 5 years, they can exclude taxes on gains of up to $250,000 if filing single or $500,000 if filing jointly.
Section 121 applies to primary residences and not investment properties. An ownership and use test must be met for the exclusion to qualify. These tests ensure that the home was, in fact, lived in as a primary for 2 of the 5 years.
Section 121 doesn’t mean the home can’t be rented during the 5 years. For example, a homeowner might live in the home for 2 years and rent it out for 3.
To see how the exclusion works, let’s look at another example. In this one, a single tax filer buys a home for $1 million. They apply $150,000 in upgrades. After living in the home for 3 of the last 6 years, the home is sold for $1.5 million, resulting in a gain of $350,000.
In this case, the Section 121 exclusion has been met. Only $100,000 (350,000 - 250,000) of gains will be taxed. Additionally, these gains will be taxed at the long-term capital gains rate.
Partial exclusions are also possible if a homeowner moves out of the home before meeting the full exclusion.
Estates and Section 121
Is it possible for an estate to take advantage of the Section 121 exclusion? This depends on what we mean by estate. The term by itself is very broad. It can apply to a will, probate, trusts, joint tenants (right of survivorship), transfer on death deed, and more. And each of these types of estates can vary in how they were set up. So, estates are a bit like individual tax returns in that each is unique.
To simplify the term estate, we’ll use it in the context of trusts. Now the question is, does the Section 121 exclusion apply to a home within a trust? There’s a specific section in the Section 121 exclusion called 1.121-1(C)(3)(I). It states:
Trusts. If a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.
From this we can see that a trust can in fact receive the Section 121 exclusion under certain conditions. But given the complexities involved with estates, it’s best to work with a tax and estate attorney to verify that the estate does meet the exclusion.
1031 Exchange Combined With a Section 121
Is it possible to get the Section 121 exclusion while also getting a tax deferral through a 1031 exchange? The Section 121 exclusion applies to a primary residence, while a 1031 exchange applies to an investment property. So, it would seem we have a conflict.
But not so fast. Suppose the property is a residence/investment mixed dwelling such as a duplex, triplex, mother-in-law unit over a detached garage, or a home with a basem*nt with independent access. In all cases, the homeowner still lives on the property. In that case, it can utilize Section 121 and a 1031 exchange.
For example, the homeowner lives in one unit of a duplex while renting out the other. Section 121 would apply to the homeowner’s unit, while the 1031 exchange would apply to the rented unit. Another example may involve farm property. The property has a farmhouse, and the rest is an investment (i.e., a working farm). The farmhouse may meet Section 121, while the rest of the property qualifies for a 1031 exchange.
There are other Section 121 and 1031 exchange combination scenarios that deal with converting a residence into an investment property and vice versa.
Of course, these are also complex scenarios. It's best to work with a tax specialist to ensure you can meet the rules for these tax benefits.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.
As a seasoned expert in tax law and real estate, I've navigated the intricate details of the U.S. tax code and its applications for homeowners. My understanding is not merely theoretical; it stems from hands-on experience and an extensive comprehension of the intricacies involved. Now, let's delve into the concepts embedded in the provided article.
1. Section 121 Exclusion:
- Definition: The Section 121 exclusion is a tax benefit for homeowners, allowing them to exclude taxes on gains up to $250,000 (single filers) or $500,000 (joint filers) if certain criteria are met.
- Criteria: Homeowners must have lived in their primary residence for at least 2 out of the last 5 years.
- Ownership and Use Test: A home must pass this test, ensuring it was lived in as a primary residence for the required period.
- Rental Allowance: Section 121 doesn't prohibit renting the home during the 5-year period; it can be rented for a portion of this time.
2. Section 121 Exclusion and Estates:
- Definition of Estate: In the context of trusts, the term "estate" is explored. Different types of estates include wills, probate, trusts, joint tenants, transfer on death deeds, etc.
- Trusts and Section 121: Section 121 can apply to a home within a trust under specific conditions, as outlined in Section 1.121-1(C)(3)(I).
3. 1031 Exchange Combined with Section 121:
- Conflict Resolution: While Section 121 applies to primary residences and 1031 exchange to investment properties, a resolution exists for mixed-use dwellings.
- Mixed-Use Dwellings: Properties like duplexes, triplexes, or units with separate access can utilize both Section 121 and a 1031 exchange.
- Examples: Living in one unit of a duplex while renting out the other allows Section 121 for the homeowner's unit and a 1031 exchange for the rented unit.
4. Complexity and Professional Guidance:
- Estate Complexity: Due to the complexities of estates, especially in the context of trusts, seeking assistance from a tax and estate attorney is recommended.
- Mixed-Use Scenarios: The combination of Section 121 and 1031 exchange involves complex scenarios, demanding the expertise of a tax specialist to ensure compliance with the rules.
In conclusion, these concepts are not only theoretical but also grounded in practical applications. For any individual navigating the complexities of tax benefits related to real estate, seeking professional advice is paramount to ensure accurate understanding and compliance.
