The § 121 Home Sale Exclusion: Ownership, Use, and the Traps

§ 121 permits exclusion from gross income of up to $250,000 of gain ($500,000 for joint filers meeting the requirements) on the sale or exchange of a principal residence. Eligibility turns on the ownership and use tests of Treas. Reg. § 1.121-1, the once-every-two-years limit of § 1.121-2, and the carve-outs and allocations of § 1.121-4.

The ownership and use tests

• Ownership. The taxpayer owned the property for periods aggregating at least 2 years during the 5-year window ending on the sale date.
• Use. The taxpayer used the property as a principal residence for periods aggregating at least 2 years during the same window.
• Periods need not be contemporaneous or consecutive; short temporary absences (vacation, illness) count as use.

Joint filers

The $500,000 cap requires either spouse to meet ownership, both spouses to meet use, and neither to have used the § 121 exclusion in the 2-year period ending on the sale date. Failure of any element drops the couple to a $250,000 cap (computed as the sum of what each spouse would have qualified for individually).

The partial exclusion

Treas. Reg. § 1.121-3 provides a reduced maximum exclusion when the sale is by reason of a change in place of employment, health, or unforeseen circumstances. The reduction is the full $250,000/$500,000 multiplied by the ratio of the shorter of (i) period of ownership and use as principal residence or (ii) period since the last excluded sale, over 2 years. The regulation supplies safe harbors for each triggering event, with facts-and-circumstances tests for the rest.

Nonqualified use allocation

§ 121(b)(5) allocates gain between qualified and nonqualified use periods after 2008. Pre-2009 rental periods are still nonqualified-use-friendly. The denominator is total ownership; the nonqualified-use numerator excludes periods after the last principal-residence use (the "qualifying use period before sale" rule preserves the back-end conversion case).

Common planning traps

• 1031-into-121. Property acquired in a like-kind exchange must be held 5 years before § 121 applies (§ 121(d)(10)).
• Surviving spouse. Two-year window after the deceased spouse's death to claim the $500,000 joint cap (§ 121(b)(4)), if requirements were satisfied immediately before death and the survivor has not remarried.
• Step-up interaction. Survivor inheriting the decedent's half basis under § 1014 can often reduce gain below the cap entirely.
• Form 4797 not Schedule D. Depreciation recapture on the business-use portion reports on Form 4797.