Real Estate Is Taxing

Examples of the 121 Exclusion which showcase how small changes, can lead to huge tax impacts.

In this episode of 'Real Estate is Taxing,' host Natalie Kolodij breaks down the intricacies of the 121 exclusion, which allows homeowners to exclude a significant amount of capital gains on the sale of their primary residence. . She details various scenarios to highlight how specific timelines and conditions—such as rental periods, military duty, and temporary absences—affect eligibility for the exclusion. By understanding these nuances, listeners can avoid costly tax errors and optimize their exclusion benefits.

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Transcript 

[00:00:00] Welcome to Real Estate is Taxing, where we talk about all things real estate tax and break down complex concepts into understandable, entertaining tax topics. My name is Natalie Kolodij I'm your host, and I am so excited that you've decided to join me.

[00:00:23] Have you ever pulled into the McDonald's drive through at 10 40 in the morning on a Sunday to get McDonald's breakfast? Only to find out the location near your house stopped serving breakfast at 10 30, you just missed it. And you were so sure you had till 11 o'clock to get that. Amazing egg McMuffin. 

[00:00:45] You've been thinking about all week. Imagine that feeling times a thousand or more. That's what today's episode is about. And the best way I could think of. To describe the [00:01:00] impact of when someone thinks they are going to qualify. For the full 1 21 exclusion and have up to a half million dollars tax free. Only to find out that the timing or the way they executed it fell a little bit short. On today's episode. I'm going to walk you guys through several different scenarios of the potential application of the 1 21 exclusion. And really point out the way a few key, little bitty timing impacts. Can lead to either a partial exclusion or in some cases, no exclusion at all. When this comes up, it is obviously something that people are pretty upset to find out. So hopefully hearing this episode ahead of time will prevent a few people from living through that experience. [00:02:00] 

[00:02:00] And maybe this episode will also remind you to check the cutoff time for your egg McMuffin this weekend. 

[00:02:06] You are the guardian of your own destiny. So let's get into things, manifest it, and to make sure we are not missing these crucial timing cutoffs. 

[00:02:16] 

[00:02:16] If you knew me, you know, the 1 21 exclusion is a code section that I can talk about for hours and hours and hours, there is so much unique complexity to it. For today's episode, we are just going to break it down into a few simplistic parts. We're taking this at a thousand foot view. So that you can recognize the reason why these situations we're going to walk through will or will not work. 

[00:02:43] And you'll be able to see how these small timing differences can create a huge difference in the taxable outcome. The 1 21 exclusion. Allows a taxpayer to exclude up to [00:03:00] $250,000 of gain or 500,000 if married. On the sale of their primary home, as long as they have owned and occupied it for two out of the most recent five years. 

[00:03:13] The first nuance to break out. That will relate to today's episode. Is those two out of five years are actually a calculation to the literal day. So two years is actually 730 days. Five years is going to be 1,825 days. For simplicity, we're ignoring leap years. So it is a literal to the day calculation. That's why a slight misjudgment on when you should move or sell, et cetera. Can have a huge impact. The next piece to be aware of for today's episode is something called non-qualified use. In a nutshell, any time when [00:04:00] that primary home. Is used for something other than being a primary home. Those years are considered. 

[00:04:06] Non-qualified use. And the gain related proportionately to those years. Typically can't be excluded under the 1 21 exclusion. Now this code provision didn't come into play until 2009. So any time of non-qualified use before that. Doesn't count does not come into play here. And there are also three key exclusions. To what is considered non-qualified use. The first one would be any rental use. That occurs after. The taxpayer's most recent use of the home as a primary residence. The second exclusion. Is if someone is active duty military. They can have potentially up to a 10 year gap. Due to [00:05:00] being active duty. Where that time, where the home is rented or not being used as a primary home. That does not count as non-qualified use. And the final exclusion. Is that a taxpayer can have up to a two year temporary absence. That can be disqualified from being non-qualified use. 

[00:05:21] So if there's a temporary absence of. Two years or less. Due to a health circumstance or a job related change or some kind of major unforeseen circumstance. That two year or less window also does not count against the calculation for the gain as non-qualified use. 

[00:05:44] Now that you are all filled in on the key items we need for today's episode. Let's run through these examples. In all of the examples I am going to walk through. We are assuming that the taxpayer [00:06:00] originally buys this property to be a primary residence the day they buy it, it is for the purpose of moving in and living in this house. So example one. Taxpayer purchases, the primary home. They own and occupy it for 730 days. 

[00:06:21] And then. They decide to sell the residence. They have occupied it and owned it for two years or more. That's 730 day mark. So in this scenario, they would qualify for their full amount of the 1 21 exclusion. 

[00:06:37] Situation too. The taxpayer purchases, a primary home. They own and occupy it for 720 days. And then they go to sell the home. Because they were shy of that 730 day mark. The amount of exclusion they qualify for is [00:07:00] going to be $0. That two year minimum. Is required unless there's an unforeseen circumstance. We're not getting into that in today's episode. So if they just decided to sell because they wanted to, there was no other reason. If they have only lived in it for that 720 days. They don't get any part of an exclusion. 

[00:07:26] There's no rounding. If they have only met that 720 day mark. Their entire gain is going to be taxable. There will be no 1 21 exclusion. 

[00:07:39] So are you starting to see why these slight differences in a calculation can have a huge impact? Let's get into a few more tricky circumstances. In the next example. Let's say the taxpayer purchases, a primary home. They own and occupy it for [00:08:00] 750 days. They then move out and rent it for 1000 days. That's 750 days gets them that two year minimum of at least seven 30. And as long as they rent it for no more than three years. They don't have any non-qualified use and they still have their full 1 21 exclusion. Three years would be 1095 days. So in this example, because the taxpayer did occupy for the minimum of 730 days. And then they did not rent it for any more than three years or 1095 days. They can sell the home at the end of this and receive their full 1 21 exclusion. The only thing that will be taxable. Is, they will have, do have payback of the depreciation they took while it was a rental. 

[00:08:53] There's going to be unrecaptured 1250 depreciation or some depreciation recapture. But otherwise. [00:09:00] That circumstance allows for a full 1 21 exclusion. The fact that it was a rental when it was sold, doesn't impede that as long as those requirements were metFor the two years of minimum occupancy and then no more than three years of rental use, they are good to go. 

[00:09:19] Next circumstance. We have a taxpayer who owned an occupy. A primary home that they purchased for 750 days. Just like the last example we know we're good. We have more than two years. The taxpayer then moves out and rents this property for 1500 days. Because they have now rented it. For more than three years, they no longer have. Two years of qualifying minimum use required. Within that five-year lookback window. Because they no longer have two years within the five-year window. [00:10:00] They now qualify for $0 of exclusion. There is no part of the 1 21 exclusion anymore. They have rented it for too long. And they lost that qualifying time. So again, Small timing differences, huge impact on the taxable outcome. 

[00:10:21] The next example. We have a taxpayer who purchases a primary home. And they own and occupy it for 720 days. So they are just shy of that two year mark. They move out and convert it to a rental for a thousand days. So they did not rent it for any more than three years. However, because they didn't meet. The core requirement of at least that 730 days of ownership and occupancy. They would receive. $0. Tax-free. Because they did not [00:11:00] hit that 730 day minimum. They do not qualify for the 1 21 exclusion. And no part of their sale will be tax-free. 

[00:11:10] The follow up question to this scenario that I've heard more than once or seen question online. As well since they were only short by 10 days, can the taxpayer. Moved back in to make up those 10 days. The answer is maybe. Let's look at how those potential scenarios would play out. So we have the same starting circumstances. Taxpayer purchases a primary home. They own and occupy it for 720 days. 

[00:11:46] So they're still shy of the 730 day minimum. They move out and rented for a thousand days. So they have rented it for less than three years. And then. The taxpayer moves back into the [00:12:00] home for 60 days. So now we have more than 730 days. Of primary use in the last five years. We also have. A total of 1,780 days of total ownership. So we haven't exceeded that five-year lookback window. So we now have a combined total. Of 780 days of primary use the original seven 20. And then the 60 more days from when they moved back in. So we have more than two years. 

[00:12:36] However. We now run into a caveat. 

[00:12:40] If you remember from the beginning of the episode, If there is use of a home where it's not being used as a primary residence. It is non-qualified use. And the gain related to that amount of time will be taxable. The exception to that. Is [00:13:00] any rental use after. The most recent. Qualifying use as a primary resident. In this situation, we have more than 730 days of primary use. 

[00:13:16] However, the rental use that. 1000 days of rental use. Occurred before. The most recent use of the home as a primary residence. That rental use happened. Before they moved back in to get that extra 60 days they needed. To hit the full two years. So now what happens? Now, what we have is a prorated gain. So because they do meet the requirements. 

[00:13:48] This taxpayer does qualify now that they have more than that two years out of five. They qualify for the 1 21 exclusion. However the time that it was [00:14:00] non-qualified the time of that thousand days of rental use in the middle. The gain related to that 1000 days. Cannot be excluded. That portion of the gain will be taxable. So 1000 days. Out of the total ownership of 1,780. Is going to be non-qualified use. What that means is when they sell. 56% of the game. We'll be taxable and only that remaining 44% would qualify for the 1 21 exclusion. But. All things considered. Are they still ending up in a better scenario? Than if they had not moved back in for 60 days. Absolutely. If they hadn't moved back in for 60 days. They wouldn't have the 730 day minimum requirement for occupancy. 

[00:14:56] Meaning a hundred percent of their gain would have been taxable. [00:15:00] So again, Slight differences in the way it plays out. I can have large impacts on the taxable outcome. 

[00:15:10] Let's look at the next example. We have a taxpayer who purchases a primary home. They own and occupy it for 720 days. So we're just shy of that two year mark. They move out and they rent it for 1100 days. In this scenario, can the taxpayer moved back in just like the last example? Can they move back in to get that 10 more days? 

[00:15:38] They need. To meet the two year requirement. They need 730 days. They are 10 days short. In this case. The answer is no. The difference here. Is the 100 additional days of rental use. If we are starting out with 720 days of primary use. [00:16:00] And we have 1100 days of rental use. If we add 10 more days, we end up being beyond the 1,825 day window for that five-year look back. If we have 720 days. Plus 1100 days, we're already at 1,820. So if the taxpayer were to move back in for 10 more to get above the 730 days. They have now also lapsed that five-year look back. So in this scenario, because there was an extra a hundred days of rental use before they decided to move back in. To reach that 730 day minimum. They would fall out of the required timeframe And they would receive. No amount of 1 21 exclusion, their gain would be fully [00:17:00] taxable. 

[00:17:00] Again, I can't reiterate this enough. Super small nuances when it comes to this code section. Can have dramatically different outcomes. I know this is a little bit of a hard episode to follow along, listening to, and at some point I will put this all into something more visual, because I think it'll be easier to follow along with. I just really want to get some of these really common, but slightly varied examples out there. 'cause I don't think people realize how quickly something can go from no tax being paid on a half million dollars to the entire half million dollars being taxable. 

[00:17:43] Let's get into the last two examples I have. And we're going to try to end things on a more positive note. So for this example, The taxpayer purchases that primary home they own and occupy it for [00:18:00] 720 days. So they are just shy of that two year mark. They move out. And rent the home for 700 days. 

[00:18:10] The reason they are renting the home for that 700 day period. Is because the taxpayer is temporarily in another state to receive medical treatment. So while they're in that other state, they're renting the home. When they are done with their treatment. They move back and they live in the home for 60 days before they decide to sell. 

[00:18:36] Again, if we think back to the very beginning of the episode. The third exclusion to non-qualified use. Is a temporary absence of no more than two years. Due to a health reason or a work-related reason or a unforeseen circumstance. So in this scenario, [00:19:00] even though we have 700 days of rental use better in the middle. I have two different primary use timeframes. Because it is less than two years of an absence. And it is due to a health-related reason. Those 700 days. Do not count as non-qualified use. This means that this taxpayer now has over 730 days. Of primary use. 

[00:19:30] So they meet that two year requirement. And they don't have any non-qualified use because it met one of the exceptions because it was a temporary absence. So when this taxpayer goes to sell this home, They would still qualify for their full 1 21 exclusion. 

[00:19:51] Another reason. I like putting these unique examples out there. Is for the tax professionals listening. [00:20:00] It's really easy to assume that if someone has these gaps where a property is rented, or if they have to sell it before the two year mark, et cetera, to default to assuming those will create taxable events. But there's quite a few nuances where that might not be the case. So the example we just covered was really similar to an earlier one. Where, because the taxpayer had lived in the home for just shy of two years, then they rented it for less than three years. 

[00:20:32] And then they moved back in so that they could hit that two year minimum of occupancy. In that case they had non-qualified use making the gain for those middle years taxable. In this case. Same situation, but because the absence, when it was rented, Was created due to a temporary qualifying absence for a medical reason. That time is not non-qualified use. 

[00:20:59] And in this [00:21:00] circumstance, they would still receive the full 1 21 exclusion. 

[00:21:05] Final example, and I promise this is as tricky as we will get. We have a taxpayer who purchases a primary home. And they own and occupy it for 750 days. So they've hit. At least 730 days, they have met that two year requirement. 

[00:21:25] This taxpayer moves out and rents the home for 700 days. Because they are at another state due to medical treatment. So while they're out of state, For this medical related temporary absence. They are renting the home. Because that is a medical related absence of no more than two years. That does not qualify for non-qualified use. We are all good there. After their medical treatment, the taxpayer moves back into the house. And they occupy it [00:22:00] for a thousand days. Because they have now reached a thousand days in the most recent five-year lookback window. 

[00:22:10] They have at least two years again. We're still good. We have not timed out from going beyond a five-year lookback. And we have at least two years of primary use within the most recent five years. And that prior 700 days of rental use. Is also not counting against them because it was a qualified, temporary absence. So the current fact pattern is. Little more than two years of primary use. Less than two years of rental use, but it was due to an exception. 

[00:22:44] So it does not create, non-qualified use. And then we have over two years of primary use. Again, they moved back in for a thousand days. 

[00:22:55] After living in the home for that thousand days after they moved back in. [00:23:00] They decide to rent it. They move out and they rent the home for a thousand days. Because this period of rental use. Is no more than three years within the last five. And this period of rental use occurred. After their most recent period of qualifying primary use. It is also an exception to non-qualified use. Okay. 

[00:23:27] So this is an example where a taxpayer lived in a primary home for a couple of years. Rented that home for a couple of years. Moved back in for a few years. Rented it for a few years. And even with all of those circumstances coming into play. When this taxpayer sells, they will still receive their full 1 21 exclusion. Because both of the periods of rental use. Meet an exception. To being defined as [00:24:00] non-qualified use. So this taxpayer in this circumstance would have the full 1 21 exclusion. And the only tax they would have would be paying back any depreciation from during those rental years,So I know today's episode was kind of a lot. It might be something you have to listen to more than once. 

[00:24:20] I know it's not the best as an audible experience, and I hope to have it in something a little more visual for you guys soon. But hopefully it got some wheels turning for you. Or maybe there's someone out there who got to hear this, and it is stopping you from moving too soon or selling too late, whatever the circumstances. And overall, I just hope it's made people a little more aware. Of how these tiny changes in the timing and the circumstances in connection to the 1 21 exclusion. Can make all of the difference. Between something being completely tax-free. [00:25:00] Partially taxable or completely taxable. Again, think back to that egg McMuffin you're dreaming of on a Sunday morning. Showing up at the drive-thru 10 minutes too late. Multiply that feeling by a thousand. That's how it would feel to barely miss. All of this money being tax-free. Because you miscalculated the timing. That's what I have for you guys today. 

[00:25:26] I want to hear your thoughts. If you have run into a situation related to a 1 21 exclusion, if you know someone that you think is going to benefit from realizing these specific timelines, they need to meet. If there's any story you have in connection to selling a primary home and having something unexpected happen, I would love to hear about it. 

[00:25:51] Find me on social com. Add me on Instagram at R E tax strategist. I've always, I hope that you gained some value from [00:26:00] today's episode. And I just want to take a second to say how appreciative I am to everyone who has been listening to the show and shared their kind words. Left a good review or shared it with friends. So you guys mean the world to me. If there is a topic that you have questions on or that you would like to hear me cover. Again, find me on social media, Ari tech strategist on Instagram.

[00:26:25] Send me a message. 

[00:26:26] Share the topic you want to hear more about. And as always, I will talk to you next week.