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The section 121 exclusion allows taxpayers to exclude a portion of the gain on the sale of their principal residence. The exclusion is significant: up to $250,000 for single filers and up to $500,000 for those filing jointly. The caveat is that the taxpayer(s) must have owned and used the property as their principal residence for any two of the five years preceding the property’s sale. This exclusion exists to promote sustainable long-term economic growth by encouraging investment in the housing market.

Most taxpayers are able to take advantage of this exclusion only a few times throughout their life as they change or upgrade residences. Some take it a step further by attempting to exclude sequential gains more frequently by changing or upgrading residences as near to the two-year minimum as possible. Finally, some taxpayers push the limits by converting rental properties into principal residences for the minimum of two years in an attempt to exclude all cumulative gains (up to the $250k/$500k limits), regardless of whether they were incurred during rental or residential years.

Congress and the IRS are always a few years behind, but they have become savvy to these loopholes. As a result, they have implemented limitations and restrictions on the exclusion of gains from the sale of a principal residence previously held as a rental property. Two significant limitations should be taken into consideration:

1. The capital gains exclusion cannot be applied to gains resulting from depreciation expense taken on rental properties after May 6th, 1997, which is the date the rule was implemented. The process of reporting these gains is called “Depreciation Recapture” and results in a maximum tax rate of 25% on any gains resulting from depreciation.

2. The capital gains exclusion is available only for periods during which the property was used as a principal residence. Any period during which it was held as a rental property is deemed “non-qualifying use”, disallowing the exclusion. Gains are considered to be earned pro-rata over the holding period and must be allocated between periods of rental and residential use.

Whether you are simply using your residence as your home, are switching houses to exclude sequential gains, or are converting rental properties to residences, the tax planning opportunities provided by the section 121 conversion rules are significant. These rules should be considered in advance of any sale or conversion in order to maximize excludible gains. Your tax professional should be well-equipped to assist you with these considerations.

If you have any questions regarding the exclusion of gains, the conversion of your rental property, or the reporting of depreciation recapture income, please do not hesitate to call your L&B professional at (858) 558-9200.

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