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Primary Residence Capital Gains Could Stall Sales
One of the most substantive tax preferences that any household receives is the IRC Section 121exclusion of up to $500,000 of capital gains (for married couples; up to $250,000 for individuals) on the sale of a primary residence, as long as the sellers owned and used the property as a primary residence for at least 2 of the last 5 years.
In practice, the rule originated in part because it was deemed “unfair” that the majority of the long-term gain in a primary residence is simply its increase in value due to inflation (and not a “real” inflation-adjusted return), but also because it’s often difficult for homeowners to actually produce years or even decades of records to substantial their true and exact cost basis in the residence (including all home improvements that may have added to basis over the years).
However, over the years, Congress has become concerned that the rule is being abused, particularly by “house flippers” who purchase a property, live it in for two years while they work on it to make improvements, and then “flip” it for a tax-free gain as a primary residence, only to then move into another investment-property-as-residence and do it again. Alternatively, investors would sometimes take a rental property, and then move into it and use it as a primary residence for 2 years, and then sell the property to absorb some or all of the gains under the primary residence exclusion, even though the bulk of the appreciation may have occurred while it was investment property (although this strategy was at least slightly curtailed under the Housing Assistance Act of 2008 by deeming investment use since 2009 as “nonqualified” use).
Nonetheless, Section 1402 of TCJA takes further steps to limit the “too-frequent” use of Section 121 for house flippers (or those repeatedly converting and moving into their rental properties to subsequently sell them as primary residences in 2 years) by changing the “owned and used for 2 out of the past 5 years” into a “5 out of the past 8 years” requirement instead (which is actually how the rules originally worked prior to 1978!), and further limiting that the Section 121 exclusion can only be used once every 5 years in the first place. As a result, owners must actually use the property as a primary residence for 5 full years, to be eligible for the capital gains exclusion, and can only use it once every 5 years regardless. (Though notably, the exception allowing for a partial use of the Section 121 exclusion is a sale occurs in less than 5 years still applies under IRC Section 121(c) is the residence is being sold due to a change in place of employment, health, or similar “unforeseen circumstances”.)
In addition, the Section 121 exclusion is further limited with an income test, which stipulates that the exclusion will phase out by $1 for every $2 above an AGI threshold of $500,000 (for married couples; $250,000 for individuals).
Example 3. Harry and Sally have lived in their primary residence for 25 years, which they originally bought for $175,000, though the property is now worth $750,000. This year, Harry sold his business, resulting in an adjusted gross income of $600,000, and upon retiring the couple decided to sell their house as well, generating an additional $575,000 of gain. Under the standard rules of Section 121, the couple could exclude $500,000 of their $575,000 gain, which increases the couple’s AGI to $675,000. However, because they are now $175,000 beyond the AGI threshold, they will lose $87,500 of their $500,000 exclusion, reducing it to only $412,500 of gains that are excluded, and increasing their AGI by another $87,500 of capital gains to $762,500.