If you lived in your home two years out of the last five years, Section 121 allow you to exempt $250,00 for single individuals and a whopping $500,00 if you are married on capital gains when you sell your home. And I am going to show you exactly how to do this.
Understanding Capital Gains Tax
So let’s understand first what is capital gains? The formula for capital gains is very simple.
It’s: Sales Price – Purchase Price – Capital Improvements = Capital Gains
What are Capital Improvements?
So what exactly are considered Capital Improvements by the IRS? Some examples of Capital Improvements are installing a new floor, replacing a roof, installing a pool, remodeling a kitchen etc… You should always take improvements like these into account when doing a Capital Gain Calculation.
A Practical Capital Gains Example
If a house sells for $550,000, you paid $200,000 for it back in the day, and you installed a pool for $50,000 that takes your capital gain to $300,000.
So if you are single, we would subtract the $300,000 of Capital Gains from the Section 121 Exemption for single filers which is $250,000. That leaves $50,000 in taxable income.
But what if you are married. So if you are married, we would subtract the $300,000 from the Section 121 Exemption for married couples couples, which is $500,000 and that leaves $0 in taxable income.
Where People Get Confused
A lot of people get confused thinking that they do not qualify for Section 121 because they have rented the property out during a portion of the last 5 years. But as long as you lived in the house two out of the last five years, you still qualify for the Section 121 Exemption as long as you have not taken the credit two years prior to that.
Section 121 Partial Credit or Partial Exclusion – Who Qualifies?
So What if You don’t Qualify for Section 121. What do you do? Well, the good news is that you can still take a partial credit on the capital gain exclusion. As we all know, life can be messy, and lots of unplanned things can happen. You might experience a health problem, job relocation, death in the family, unexpected multiple births, or loss of income. Because of these life changing events you can find yourself not being able to afford the home you are living in. If you find yourself in any of these situations, you will want to document everything very carefully because you can qualify for a partial exclusion and still save yourself a lot of money.
So how does this look? Let’s go over an example together.
How the Section 121 Partial Exclusion Works
So if you have a life situation, like any of ones just described, and you lived in the home for 1 of the required 2 years (over the last 5 years), you would qualify for a 50% partial exclusion.
Here is a practical example of what that would look like for both single filers and married couples.
So if we still assume that property sells for $550,000, you paid $200,000 and spent $50,000 on home improvements, your capital gain is $300,000.
And if you are single, we subtract the $300,000 of Capital Gains from the Section 121 Partial Exemption (50% or half of $250,000) which is $125,000. Now, that leaves $175,000 in taxable income.
For married couples, we subtract the $300,000 of Capital Gains from the Section 121 Partial Exemption (50% or half of $500,000) which is $250,000. And that leaves just $50,000 in taxable income.
Why Work with a Tax Professional?
Section 121 is a great start to reducing your taxable incincome,t you may find that you qualify for even more deductions tax credits which can reduce your tax liability down even further. A lot times, we recommend working with a tax professional or licensed CPA, they can remind or share with of tax savings strategies that the average person would never think about on their own. By working with a tax professional, it can be possible to get those capital gains down to $0.