What Is a Section 121 Exclusion? Definition, Example and Basics

The Section 121 Exclusion is an IRS rule that allows you to exclude from taxable income a gain of up to $250,000 from the sale of your principal residence. ¹ A couple filing a joint return can exclude up to $500,000. The exclusion gets its name from the part of the Internal Revenue Code that allows it. To claim the exclusion, a taxpayer must own and use the home as their main residence for a period adding up to two of the five years prior to selling.

A financial advisor can help ensure you’re getting all the credits, exemptions and deductions you‘re eligible for.

Section 121 Exclusion Basics

The Section 121 Exclusion, also known as the principal residence tax exclusion, lets people who sell their primary homes avoid paying taxes on a certain portion of their gains. There is no requirement that they use the proceeds to purchase a second home. The principal residence does not necessarily have to be in the United States.

There are, however, some restrictions. For one, the exclusion is not available to investors who buy homes for rental purposes. Likewise, people who sell secondary residences, such as vacation homes, can’t use the exclusion. It’s also generally not available to people who frequently buy and sell primary homes. Property used in a trade or business can’t benefit from the exclusion either.

The IRS requires a taxpayer who gets a Form 1099-S reporting proceeds from real estate transactions to report the gain on their tax return. That’s the case even if the gain is excludable under Section 121. Taxpayers use Schedule D, part of Form 1040 and Form 8949 to report gains on these sales.

Ownership and Use Test for Section 121 Exclusions

The main restriction on using the Section 121 Exclusion is the ownership and use test. This requires that the taxpayer has owned the home and used it as a primary residence for at least 24 months out of the previous 60 months. The 60-month period ends on the date the home is sold. The 24 months do not have to be consecutive.

For instance, a taxpayer could qualify for the exemption if they lived in the home for a year, moved out for three years and then used it again as a primary residence the last year. It’s also allowable to meet the ownership and use tests during different two-year periods.

A homeowner who uses the home for business purposes, such as rental property, for part of the preceding five years, would only be able to exclude a portion of the gain, however. The amount of the gain they could exclude would depend on the proportion of time they used the home for business purposes.

As an example, let’s say a taxpayer lived in a home for two of the five years. They rented it out for three of those five years. In that case, they could not exclude three-fifths of the gain on the sale. The IRS would instead treat that portion of the gain as taxable income.

Another limitation of the exclusion is that the taxpayer can only use it every two years. If a taxpayer sold a home and took the exclusion at any time during the two years before the date of the home’s sale, the exclusion wouldn’t apply.

Special Exemptions

There are special cases when a home seller can use the exclusion test more liberally. This includes when a home seller has had a change of employment or health issues, or has experienced other unforeseen circumstances.

There is also a specific provision for taxpayers or their spouses who are serving in the military and have been stationed for more than 90 days more than 50 miles from home or ordered to live in government housing. In these cases, the taxpayer can elect to suspend the usual five-year period for up to 10 years. A similar exemption applies to taxpayers or spouses in the government foreign service or intelligence community.

How Partial Exclusions Work Under Section 121

Some taxpayers may qualify for a reduced Section 121 exclusion if they don’t meet the full ownership and use requirement. The IRS allows a partial capital gains exemption when the primary reason for the home sale is a change in workplace location, health issues or other unforeseen circumstances. The reduced exclusion lets taxpayers exclude a portion of the $250,000 or $500,000 limit based on the applicable period used in the IRS calculation.

To calculate a partial exclusion, compare the shortest of the taxpayer’s period of residence, period of ownership or, if applicable, the time since the taxpayer last claimed the exclusion to the full two-year requirement. The allowed exclusion is the same proportion of the maximum exclusion. For example, if a taxpayer lived in a home for one year instead of two and sold the home due to a qualifying reason, they may be able to exclude up to half of the usual limit. This would mean up to $125,000 for a single filer, or up to $250,000 for a joint filer.

The IRS defines qualifying reasons narrowly. A change in employment must involve a new job or work location that generally is at least 50 miles farther from the home than the prior work location. A move for health reasons can qualify in several circumstances, including when a doctor recommends a change in residence because of a health problem. Unforeseen circumstances can include events such as natural disasters, death, divorce or property damage. Each situation must meet IRS criteria to qualify for a partial exclusion.

Bottom Line

The Section 121 Exclusion can significantly reduce taxes when selling a principal residence, allowing some to avoid paying the capital gains tax entirely. Section 121 excludes income up to $250,000 for an individual taxpayer and $500,000 for a couple filing jointly. To qualify, taxpayers must own and use a property as their primary residence for two of the five years before the sale. Houses cannot be used as real estate investment properties, rent houses, second and vacation homes or business properties. Further, the exclusion can only be used once every two years.

Tips on Taxes

• To ensure you aren’t missing out on any money-saving tax moves, consider talking to a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. Then, you can have a free introductory call with your matches to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• The federal government taxes income in America, most state governments and many local governments. The federal income tax bracket system is progressive, so the rate of taxation increases as income increases. Here’s a free federal income tax calculator that will give you a good idea of what you’ll owe Washington.

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