The home sale gain exclusion in today’s market

Sec. 121 provides a significant tax benefit by allowing taxpayers to exclude from gross income, within limits, gain from the sale of their principal residence (the home sale gain exclusion). With the recent surge in housing prices, more taxpayers will exceed the exclusion’s applicable limit and realize taxable gains when they sell their home. This article discusses the basic provisions of Sec. 121 and situations in which taxpayers qualify for full or partial exclusion of gain on the sale or exchange of their principal residence.

Over the past four years, the U.S. housing market has experienced a 47% increase in prices (“US Home Prices Have Soared 47% So Far This Decade, Outpacing All of the Growth Seen in the 1990s and 2010s,” Business Insider (May 10, 2024)). Many states have seen more than a 100% increase in housing prices in the past 10 years (“Cities With the Largest Increase in Home Prices Over the Last Decade,” Construction Coverage (updated Jan. 8, 2025)). While the COVID-19 pandemic fueled a first-time homebuyers’ frenzy and increased demand by Millennials for home ownership post-pandemic, the rise in mortgage rates after 2020 reduced supply as current homeowners became reluctant to sell and refinance at higher rates, a trend that is likely to persist (“Higher Mortgage Rates Likely to Keep Existing Home Sales Near Multi-Decade Lows,” Fannie Mae (Jan. 22, 2025)).

For homeowners who do sell, rising housing prices will lead to larger-than-ever gains on the sale of a home, creating more instances where the maximum home sale gain exclusion amounts under Sec. 121(b) (up to $250,000, or if married filing jointly, $500,000) may be surpassed and result in taxable gains. These exclusion amounts have not been indexed for inflation and have remained at $250,000/$500,000 since 1997.

Now more than ever, practitioners need to be well versed in the Sec. 121 requirements for the home gain sale exclusion. This article first describes the general eligibility rules for the exclusion, then delves into some special rules and exceptions, and finally focuses on situations where a partial but not full exclusion is available.

ELIGIBILITY REQUIREMENTS

Sec. 121 allows a taxpayer to exclude from gross income a limited amount of gain on the sale or exchange of property that, during the five-year period ending on the date of the sale or exchange, has been owned (ownership test) and used (use test) by the taxpayer as the taxpayer’s principal residence for periods aggregating to two years or longer (Sec. 121(a)). In addition, the exclusion generally can be claimed only once every two years (the lookback requirement) (Sec. 121(b)(3)).

Many individuals own multiple homes, and a question may arise as to which is their principal residence. This is determined by all the facts and circumstances. If the taxpayer lives in more than one home, the principal residence is usually the one the taxpayer uses the majority of the time. Other factors considered in determining which home is the principal residence include, but are not limited to:

• The address where the taxpayer receives bills and correspondence or that is listed on the taxpayer’s voter registration card, federal and state tax returns, driver’s license, and car registration.
• The locations of the taxpayer’s employment, banks, and recreational clubs or religious organizations with which the taxpayer is affiliated.
• The principal place of abode of family members (Regs. Sec. 1.121-1(b)(2)).

For married taxpayers filing jointly, to obtain the full home sale gain exclusion, only one spouse needs to meet the ownership test. However, each spouse must meet the use test, although the use of the residence need not have occurred while the spouses were married or at the same time (Secs. 121(b)(2)(A)(i) and (ii)).

For unmarried taxpayers filing separate returns who jointly own a home to each qualify for the home sale gain exclusion on their interest in the home, each taxpayer must meet both the ownership and use tests (Regs. Sec. 1.121-2(a)(4), Example (1)).

Example: Dan and Jen, an unmarried couple, decide to sell their shared home in 2024. Dan and Jen jointly bought the house in 2017 and have used it continuously as their principal residence. For Dan and Jen to both qualify for the home sale gain exclusion of up to $250,000, as an unmarried couple, they both need to meet the ownership and use tests. Dan and Jen both meet the ownership test because they have jointly owned the home for at least two years during the five-year period prior to the sale. They both meet the use test because they have each lived in the home as their principal residence for at least two years during the five-year period prior to the sale. Since both Dan and Jen satisfy both tests, even though they are not married, they can each exclude from gross income up to $250,000 of gain on the sale of the property.

A rule worth noting is that if a taxpayer becomes physically or mentally unable to care for himself or herself and the taxpayer owns a home and uses it for periods aggregating at least one year during the five years preceding the sale, any time the taxpayer resides in any facility (including a nursing home) licensed by a state or political subdivision of a state during the five-year period in which the taxpayer owns the property counts toward the use test. In addition, short absences, such as for vacations or other seasonal absences, are counted as periods of use (Regs. Sec. 1.121-1(c)(2)).

A taxpayer meets the lookback requirement for a sale or exchange if he or she did not sell another home during the two-year period ending on the date of the sale or exchange or if the taxpayer did sell another home within the two-year period but did not exclude gain from the sale (Sec. 121(b)(3)).

SOME SPECIAL RULES AND EXCEPTIONS

Other noteworthy points about the home sale gain exclusion include:

• The use of a home owned by a taxpayer by the taxpayer’s spouse or former spouse who is granted use of the property under a separation or divorce instrument is treated as use of the home as principal residence by the taxpayer for purposes of the use test (Sec. 121(d)(3)(B)).
• The period of use and ownership of a home by the taxpayer’s deceased spouse will be included in the taxpayer’s period of ownership and use of the home if the taxpayer has not remarried. However, for the $500,000 exclusion (rather than the $250,000 exclusion) to apply, the sale of the home must occur within two years after the spouse’s death (Secs. 121(d)(2) and (b)(4)).
• At the election of the taxpayer, a sale or exchange of a remainder interest in a principal residence to an unrelated party is a sale or exchange for purposes of the home sale gain exclusion (Sec. 121(d)(8)).
• A sale or exchange for purposes of the home sale gain exclusion can include the destruction, theft, seizure, reacquisition, or condemnation of property (Sec. 121(d)(5)).
• At the election of a taxpayer with respect to a home, the running of the five-year ownership and use test periods is suspended during any period during which the taxpayer or his or her spouse serves on qualified official extended duty as a member of the uniformed services, foreign service of the United States, or employee of the intelligence community (Sec. 121(d)(9)).
• If the taxpayer acquired a home in a Sec. 1031 like-kind exchange, the home sale gain exclusion does not apply to the sale or exchange of the home by the taxpayer for a five-year period beginning with the date of the acquisition (Sec. 121(d)(10)).
• The home sale gain exclusion does not apply to any portion (separate from the dwelling unit) of a home sold or exchanged that the taxpayer used for nonresidential purposes (e.g., business or rental). The term “dwelling unit” has the same meaning as in Sec. 280A(f)(1) but does not include appurtenant structures or other property (Regs. Sec. 1.121-1(e)).
• The home sale gain exclusion does not apply to so much of the gain from the sale or exchange of a home as is allocated to periods of nonqualified use (Sec. 121(b)(5)(A)). A period of nonqualified use includes, with certain exceptions, any period (other than the portion of any period preceding Jan. 1, 2009) during which the home is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse. Note that this allocation is based on the taxpayer’s entire ownership period of the home, not just the five years encompassed in the ownership and use tests. Gain is allocated to periods of nonqualified use based on the ratio that the aggregate periods of nonqualified use during the period such property was owned by the taxpayer bears to the period the property was owned by the taxpayer (see “Converting a Rental or Vacation Home Into a Primary Residence,” The Tax Adviser (Aug. 1, 2024), and “How the Loophole in IRC Section 121 Can Benefit Homeowners,” The CPA Journal (January 2020)).

In all of these and other situations enumerated in Sec. 121(d) and the regulations, the facts and circumstances of the ownership and use of a home must be thoroughly examined to determine if any of the gain from its sale can be excluded from gross income under the home sale gain exclusion.

PARTIAL EXCLUSION OF GAIN

Sometimes taxpayers are ineligible for the full Sec. 121 home sale gain exclusion because circumstances cause them to relocate to a different home in less than two years after its purchase. However, where a taxpayer does not qualify for the maximum exclusion of gain under Sec. 121(a), in certain situations, a partial exclusion of gain under Sec. 121(c) might still be available where the main reason for the sale or exchange of a home was a change in place of employment location (Regs. Sec. 1.121-3(c)), health (Regs. Sec. 1.121-3(d)), or unforeseen circumstances (Regs. Sec. 1.121-3(e)).

Change in employment location: A taxpayer meets the requirements for a partial exclusion of gain under Sec. 121(c) for this reason if any of the following events occurred during his or her time of ownership and residence in the home:

• The taxpayer took or was transferred to a new job in a work location at least 50 miles farther from the home than the taxpayer’s old work location.
• The taxpayer did not have a previous work location and began a new job at least 50 miles from the home.
• Either of the above is true of the taxpayer’s spouse, a co-owner of the home, or anyone else for whom the home was their residence.

Health: A taxpayer meets the requirements for a partial exclusion of gain under Sec. 121(c) for this reason if, during his or her time of ownership and residence in the home:

• The taxpayer moved to obtain, provide, or facilitate diagnosis, cure, mitigation, or treatment of disease, illness, or injury for the taxpayer or a family member. (Family members for this purpose include the taxpayer’s parent; grandparent; stepparent; child (including adopted child, eligible foster child, or stepchild); grandchild; sibling (brother, sister, step- or half-sibling); mother-in-law; father-in-law; brother-in-law; sister-in-law; son-in-law; daughter-in-law; uncle; aunt; nephew; or niece.)
• The taxpayer moved to obtain or provide medical or personal care for a family member suffering from a disease, illness, or injury.
• A doctor recommended a change in residence because the taxpayer was experiencing a health problem (not including a mere benefit to general health or well-being).
• Any of the above is true of the taxpayer’s spouse, a co-owner of the home, or anyone else for whom the home was their residence.

Unforeseen circumstances: A taxpayer meets the requirements for a partial exclusion of gain under Sec. 121(c) for this reason if any of the following events occurred during the time the taxpayer owned and lived in the home sold:

• The home was destroyed or condemned.
• The home suffered a casualty loss because of a natural or man-made disaster or an act of terrorism, regardless of whether the loss is deductible.
• The taxpayer or his or her spouse, a co-owner of the home, or anyone else for whom the home was their residence died; became divorced or legally separated or were issued a separate decree to pay maintenance (support) to the other spouse; gave birth to two or more children from the same pregnancy; became eligible for unemployment compensation; or became unable because of a change in employment status to pay basic living expenses for the household (including expenses for food, clothing, housing, medication, transportation, taxes, court-ordered payments, and expenses reasonably necessary for making an income).
• An event occurred that has been determined to be an unforeseeable event in IRS published guidance.

Other facts and circumstances: Even if the taxpayer’s situation does not match the safe-harbor requirements discussed above, a taxpayer may still qualify for a partial exclusion of gain under Sec. 121(c) if, based on the taxpayer’s facts and circumstances, the primary reason for the taxpayer’s sale or exchange of the home is employment-related, health-related, or unforeseeable (Regs. Sec. 1.121-3(b)). Factors that may be relevant in determining the taxpayer’s primary reason for the sale or exchange include (but are not limited to) the extent to which:

• The circumstances causing the sale of the home arose during the time the taxpayer owned and used the home as his or her principal residence;
• The circumstances causing the sale of the home and the sale are close in time;
• The circumstances causing the sale of the home could not have reasonably been anticipated when the taxpayer began using the home as a principal residence;
• The taxpayer’s financial ability to maintain the property is materially impaired; or
• The suitability of the home as the taxpayer’s principal residence materially changes.

CALCULATION OF PARTIAL EXCLUSION

The partial exclusion of the gain under Sec. 121(c) is calculated proportionally. It is based on a fraction, the numerator (which can be expressed in days or months) of which is the shortest of: the period that the taxpayer owned the home during the five-year period ending on the date of the sale or exchange; the period the taxpayer used the home as the taxpayer’s principal residence during the five-year period ending on the date of the sale or exchange; or the period between the date of a prior sale or exchange of a home for which the taxpayer excluded gain under Sec. 121 and the date of the current sale or exchange. The denominator is 24 months or 730 days (Regs. Sec. 1.121-3(g)(1)).

For example, a taxpayer who files as single purchases a home that she uses as her principal residence. Twelve months after the purchase, the taxpayer sells the home due to a change in her place of employment. The taxpayer has not excluded gain under the home sale gain exclusion on a prior sale or exchange of a home within the last two years. The taxpayer is eligible to exclude up to $125,000 of the gain from the sale of the home (12/24 × $250,000) (Regs. Sec. 1.121-3(g)(2), Example (1)).

RISING HOME PRICES

Since 1997, Sec. 121 has provided an exclusion from gross income of gain on the sale of a principal residence as long as certain requirements are met. The maximum exclusion amounts, however, have remained static at $250,000 or $500,000 without any adjustment for inflation. As rising housing prices trigger substantial increases in real estate wealth, more taxpayers will realize taxable gains when they sell their home. Tax practitioners need to be well acquainted with the provisions of Sec. 121, including those that allow a taxpayer to partially exclude the gain on the sale or exchange of a principal residence.

About the authors

Andrew Lafond, CPA, DBA, and Kristin Wentzel, Ph.D., are professors at La Salle University in Philadelphia. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.

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