Examples of the 121 Exclusion which showcase how small changes, can lead to huge tax impacts.

In this episode of 'Real Estate is Taxing,' host Natalie Kolodij breaks down the intricacies of the 121 exclusion, which allows homeowners to exclude a significant amount of capital gains on the sale of their primary residence. . She details various scenarios to highlight how specific timelines and conditions—such as rental periods, military duty, and temporary absences—affect eligibility for the exclusion. By understanding these nuances, listeners can avoid costly tax errors and optimize their exclusion benefits.

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Transcript 

[00:00:00] Welcome to Real Estate is Taxing, where we talk about all things real estate tax and break down complex concepts into understandable, entertaining tax topics. My name is Natalie Kolodij I'm your host, and I am so excited that you've decided to join me.

[00:00:23] Have you ever pulled into the McDonald's drive through at 10 40 in the morning on a Sunday to get McDonald's breakfast? Only to find out the location near your house stopped serving breakfast at 10 30, you just missed it. And you were so sure you had till 11 o'clock to get that. Amazing egg McMuffin. 

[00:00:45] You've been thinking about all week. Imagine that feeling times a thousand or more. That's what today's episode is about. And the best way I could think of. To describe the [00:01:00] impact of when someone thinks they are going to qualify. For the full 1 21 exclusion and have up to a half million dollars tax free. Only to find out that the timing or the way they executed it fell a little bit short. On today's episode. I'm going to walk you guys through several different scenarios of the potential application of the 1 21 exclusion. And really point out the way a few key, little bitty timing impacts. Can lead to either a partial exclusion or in some cases, no exclusion at all. When this comes up, it is obviously something that people are pretty upset to find out. So hopefully hearing this episode ahead of time will prevent a few people from living through that experience. [00:02:00] 

[00:02:00] And maybe this episode will also remind you to check the cutoff time for your egg McMuffin this weekend. 

[00:02:06] You are the guardian of your own destiny. So let's get into things, manifest it, and to make sure we are not missing these crucial timing cutoffs. 

[00:02:16] 

[00:02:16] If you knew me, you know, the 1 21 exclusion is a code section that I can talk about for hours and hours and hours, there is so much unique complexity to it. For today's episode, we are just going to break it down into a few simplistic parts. We're taking this at a thousand foot view. So that you can recognize the reason why these situations we're going to walk through will or will not work. 

[00:02:43] And you'll be able to see how these small timing differences can create a huge difference in the taxable outcome. The 1 21 exclusion. Allows a taxpayer to exclude up to [00:03:00] $250,000 of gain or 500,000 if married. On the sale of their primary home, as long as they have owned and occupied it for two out of the most recent five years. 

[00:03:13] The first nuance to break out. That will relate to today's episode. Is those two out of five years are actually a calculation to the literal day. So two years is actually 730 days. Five years is going to be 1,825 days. For simplicity, we're ignoring leap years. So it is a literal to the day calculation. That's why a slight misjudgment on when you should move or sell, et cetera. Can have a huge impact. The next piece to be aware of for today's episode is something called non-qualified use. In a nutshell, any time when [00:04:00] that primary home. Is used for something other than being a primary home. Those years are considered. 

[00:04:06] Non-qualified use. And the gain related proportionately to those years. Typically can't be excluded under the 1 21 exclusion. Now this code provision didn't come into play until 2009. So any time of non-qualified use before that. Doesn't count does not come into play here. And there are also three key exclusions. To what is considered non-qualified use. The first one would be any rental use. That occurs after. The taxpayer's most recent use of the home as a primary residence. The second exclusion. Is if someone is active duty military. They can have potentially up to a 10 year gap. Due to [00:05:00] being active duty. Where that time, where the home is rented or not being used as a primary home. That does not count as non-qualified use. And the final exclusion. Is that a taxpayer can have up to a two year temporary absence. That can be disqualified from being non-qualified use. 

[00:05:21] So if there's a temporary absence of. Two years or less. Due to a health circumstance or a job related change or some kind of major unforeseen circumstance. That two year or less window also does not count against the calculation for the gain as non-qualified use. 

[00:05:44] Now that you are all filled in on the key items we need for today's episode. Let's run through these examples. In all of the examples I am going to walk through. We are assuming that the taxpayer [00:06:00] originally buys this property to be a primary residence the day they buy it, it is for the purpose of moving in and living in this house. So example one. Taxpayer purchases, the primary home. They own and occupy it for 730 days. 

[00:06:21] And then. They decide to sell the residence. They have occupied it and owned it for two years or more. That's 730 day mark. So in this scenario, they would qualify for their full amount of the 1 21 exclusion. 

[00:06:37] Situation too. The taxpayer purchases, a primary home. They own and occupy it for 720 days. And then they go to sell the home. Because they were shy of that 730 day mark. The amount of exclusion they qualify for is [00:07:00] going to be $0. That two year minimum. Is required unless there's an unforeseen circumstance. We're not getting into that in today's episode. So if they just decided to sell because they wanted to, there was no other reason. If they have only lived in it for that 720 days. They don't get any part of an exclusion. 

[00:07:26] There's no rounding. If they have only met that 720 day mark. Their entire gain is going to be taxable. There will be no 1 21 exclusion. 

[00:07:39] So are you starting to see why these slight differences in a calculation can have a huge impact? Let's get into a few more tricky circumstances. In the next example. Let's say the taxpayer purchases, a primary home. They own and occupy it for [00:08:00] 750 days. They then move out and rent it for 1000 days. That's 750 days gets them that two year minimum of at least seven 30. And as long as they rent it for no more than three years. They don't have any non-qualified use and they still have their full 1 21 exclusion. Three years would be 1095 days. So in this example, because the taxpayer did occupy for the minimum of 730 days. And then they did not rent it for any more than three years or 1095 days. They can sell the home at the end of this and receive their full 1 21 exclusion. The only thing that will be taxable. Is, they will have, do have payback of the depreciation they took while it was a rental. 

[00:08:53] There's going to be unrecaptured 1250 depreciation or some depreciation recapture. But otherwise. [00:09:00] That circumstance allows for a full 1 21 exclusion. The fact that it was ...