Section 121: Exclusion of Gain from Sale of Principal Residence

NAHB Policy

NAHB reaffirms its commitment to the incentives currently in existence in the nation’s tax system, which make housing a reality for a substantially greater group of Americans across the entire income spectrum. Further, NAHB strongly urges Congress to oppose any tax revisions that do not take into account the special importance of housing to the economy and to the stability of neighborhoods and communities. (9/95 Resolution #1A)

Present Law

Under present law, an individual may exclude from income up to $250,000 of gain ($500,000 on a joint return in most situations) realized on the sale or exchange of a principal residence (Code Section 121(b)). The exclusion may not be used more frequently than once every two years (Section 121(b)(3)).

In general, gain may only be excluded if, during the five-year period that ends on the date of sale or exchange of the residence, the individual owned and used the property as a principal residence for two years or more. Short, temporary periods of absence (i.e. vacation or seasonal absence) are counted as use, even if the residence is rented during this period. However, a year is not considered a short period of absence. A special exception to this rules applies for certain members of the military (Section 121(d)(9)).

However, owners of more than one home should be aware of rules that begin in 2009. The new rule narrows the existing exclusion for owners of second homes. Home owners who own only one home are not affected at all by the new rules and may continue to exclude up to $500,000 or $250,000 in gain from the sale of their principal residence.

Under the change in tax law, taxpayers must continue to meet the existing test of living in the home for two of the five years preceding the sale, but the maximum amounts that can be excluded from taxation are reduced proportionately by the number of years (or time periods) in which they owned the home but did not occupy it as a primary residence.

For example, suppose a taxpayer purchases a second home on Jan. 1, 2009 and sells it 10 years later on Jan. 1, 2019, using it as a primary residence only during 2017 and 2018. The two-of-five year test has been met, but because the home was only used as a primary residence for 20% of the total ownership period (two of the 10 years), the $500,000 ($250,000) gain exclusion cap is reduced by 80% to $100,000 ($50,000).

NAHB insisted on important grandfathering exceptions for existing owners of second homes. Under these exceptions, any time period of ownership prior to Jan. 1, 2009 is treated as a period of primary residency for the purpose of calculating the nonqualified use.

For example, suppose a taxpayer purchased a second home on Jan. 1, 2005 and sells the residence on Jan. 1, 2015, using the home as a primary residence only during 2013 and 2014. Unlike the previous example, in which the taxpayer could only qualify for two years of using the home as a principal residence, under the new law’s grandfathering rule six of the 10 years qualify for the tax exemption — 2005, 2006, 2007 and 2008, as well as 2013 and 2014. The taxpayer is able to exclude up to 60% (six of 10 years of qualified use) of the $500,000 ($250,000) gain exclusion amounts, or $300,000 ($150,000.)

There are other exceptions to how the law defines nonqualified use; most notably, any period of ownership within the five-year window after the two-year test has been satisfied can be considered a period of qualified principal residence use. For example, if a home is used as a primary residence in 2010 and 2011, then years 2012 through 2014 are treated as years of primary residency even if the home was used for other purposes, including rental or vacation property.

Legislative History

Section 121 was established in its present form by the Taxpayer Relief Act of 1997. Prior to the 1997 Act, taxpayers were permitted a one-time exclusion provided the taxpayer was at least 55 years of age. Technical changes to Section 121 were made by the IRS Restructuring and Reform Act of 1998. The rules concerning second homes were substantially modified by H.R. 3221, the Housing and Economic Recovery Act of 2008.

Regulatory Background

An individual cannot claim the exclusion for any portion of the gain that is allocable to a portion of the property that is separate from the actual residence and not used as a residence (Reg. Sec. 1.12101(e)(1)).

The $500,000 limitation for joint filers is allowed if either spouse meets the 2-year ownership test, both spouses meet the ownership test, and neither spouse is ineligible due to a previous sale or exchange with the prior two years. When a spouse dies before the date of sale, the surviving spouse is considered as owning and living in the home for the same period as the deceased spouse (Reg. Sec. 1.121-4(a)). However, the surviving spouse may not claim the $500,000 exclusion.

A partial exclusion is available for home sellers not meeting the 2-year ownership test. Taxpayers may claim a partial exclusion for the following reasons: a change of employment, health reasons, or unforeseen circumstances (Section 121(c)(2)). The partial exclusion is computed by multiplying the maximum allowable exclusion (e.g. $250,000 or $500,000) by a fraction. The numerator of the fraction is equal to the shortest of the period of time the individual owned and used the residence as a principal residence during the previous five-year period or the period of time between the date of the most recent prior sale or exchange to which the exclusion applied. The denominator is in general equal to 740 days (Reg. Sec. 1.121-3(g)).

Taxpayers are not required to allocate the appropriate portion of the basis of the property between residential and business use for that portion of the home that was used for business or used to produce rental income. However, any depreciation taken on the home is treated as taxable gain upon sale or exchange (Section 121(d)(6) and Reg.Sec. 1.121-1(d)(1)).

The exclusion applies to gain on the sale or exchange of a remainder interest in a principal residence, providing the person acquiring the property is not a member of the taxpayer’s family or another related person, as defined by Section 267(b) or 707(b). The exclusion is not available to expatriates (Section 121(e)). For the purpose of the Section 1033 involuntary conversion gain exclusion rules, the amount of gain excluded is equal to the amount of the realized gain reduced by the appropriate $250,000/$500,000 exclusion (Section 121(d)(5)).

The ownership of stock in a cooperative housing corporation is the equivalent of ownership of a residence for the purposes of Section 121, provided other relevant tests are satisfied.

An individual who is qualified to exclude all of the realized gain from the sale of a home is not required to report the sale on the individual’s tax return.


Under prior law, no gain was recognized on the sale of a principal residence if a new residence of at least equal cost was purchased and used by the taxpayer as a principal residence within a specified period of time. The basis of the replacement residence was reduced by the amount of the non-recognized gain. Also under prior law, an individual, on a one-time basis, could exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence if the taxpayer (1) had attained age 55 before the sale, and (2) had owned the property and used it as a principal residence for three or more of the five years preceding the sale.

Congress eliminated this set of tax rules with respect to the sale of a principal residence and replaced it with Section 121 in 1997. The legislative history indicates that this new section was established to reduce taxpayer burden. The committee report notes that the calculation of capital gain from the sale of a principal residence was among the most complex tasks faced by individual taxpayers.

An outstanding issue with the exclusion is the fact that the exclusion amounts were not indexed to inflation. Consequently, inflation will erode the value of the exclusion over time, thereby undermining the Congressional intent with respect to Section 121.

With respect to the rule changes for second homes, Congress made these changes to the principal residence gain exclusion for two reasons. First, for some time there was a desire to tighten the gain exclusion rules so that they applied only to owner-occupied principal residences and not to homes held primarily as rental property, which thereby received an unfair tax advantage over other owners of residential rental property, including multifamily developers. The provision was almost included in the Mortgage Forgiveness Debt Relief Act of 2007, which exempted from tax mortgage forgiveness amounts or interest rate reductions on a principal residence.

Second, congressional leadership insisted on making the Housing and Economic Recovery Act of 2008 revenue neutral. The change to the principal residence gain exclusion rules was one of many revenue-raising provisions included for this purpose and needed to enact the landmark housing stimulus package. The provision raises approximately $1.4 billion over 10 years — about 0.5% of the tax expenditure of the prior rules.


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