The real estate market, especially in Texas, is on fire and we’re fielding a ton of questions regarding potential sales and their tax impact. Section 121 allows taxpayers a huge tax benefit if you lived in the home for at least two of the five years prior to the sale. There is a potential $500K gain exclusion ($250K if non-married). Many taxpayers can wipe out their entire gains if they meet the use test. There are several nuances that can make a big difference.
Depreciation Recapture
If the property is your primary residence the entire time, then you are good to take the full exclusion to wipe out your gain. One exception is for depreciation recapture in the event you claimed a deduction for your home office. This does need to be recaptured and you’ll pay tax on that part of the gain. This is usually a small amount of the overall transaction.
Non-Qualified Use
It gets much trickier when the property has non-qualified use. Non-qualified use involves time when the property was not your primary residence. In this case, you may only qualify for a partial exclusion based on the ratio of qualified use over length of ownership. For example, if you purchased a rental property, rented it for three years and then lived in it for three years, you’d only qualify for a 50% gain exclusion.
There is a huge benefit hidden in section 121(b)(5)(C)(ii)(I) that can be seen in the following example. Let’s say you owned a primary residence for 3 years and then rented it for 3 years before selling. In this case, you just squeeze in with regard to the 2 out of 5-year test. More importantly, you qualify for a full exclusion because of the section 121(b)(5)(C)(ii)(I) exception. This rule says any period of non-qualified use does not include the time after it was a primary residence during that 5-year timeframe. In other words, the time after you move out is not included if it’s still part of the 5-year window where you qualify for the exclusion. This turns our 50% exclusion in the previous paragraph into a 100% exclusion in the most recent example. So the general idea is turn it into a rental AFTER you live their vs. the other way around.
The Two-Year Rule
Timing is crucial with section 121 and you also need to be aware of the other two-year rule. You can only claim this exclusion every two years under code section 121(b)(3). This is based on the time between the last section 121 exclusion meaning you can have one on Jan 1, 2020 and another on Jan 2, 2022 or one on Dec 31, 2020 and another on Jan 1, 2023. Remember that any depreciation taken during the rental period will be subject to the 1250 recapture rules.
Rental Property Passive Losses
One other huge benefit to be aware of involves rental properties and passive losses. In the year you report a gain from the sale of a rental, you have passive income with respect to that gain. That affords you the ability to write off passive losses in that year. In these years, you may want to consider making repairs to other rentals that will directly reduce your taxable income. It may also be a good year to look at a cost segregation study where you will actually feel the benefit instead of just increasing your loss carryforwards.
The tax rules with real estate are extremely complex. We can help you navigate the real estate professional rules, passive activity loss rules, short-term rental treatment, cost segregation studies, 1031 tax-free exchanges, qualified opportunity zones and many more. Contact our CPA office in Austin TX with any questions!
