The home-sale exclusion (Section 121)
When you sell your main home, you can exclude up to $250,000 of gain from income, or $500,000 if you’re married filing jointly. To qualify, you must have owned the home and lived in it as your main home for at least two of the five years before the sale, and you generally can’t have used the exclusion on another home in the previous two years. The two years don’t have to be consecutive.
These dollar limits were set in 1997 and have never been adjusted for inflation. If you bought in the 1990s or early 2000s, your gain may be well above the exclusion, and the excess is taxed as a long-term capital gain.
Where a 1031 exchange comes in
A 1031 exchange defers tax on investment or business real estate. It doesn’t apply to a personal residence. But once you move out and rent the home, it becomes investment property. If it then qualifies for both provisions at the time of sale, the IRS allows you to use them together (Revenue Procedure 2005-14):
- Exclude up to $250,000 / $500,000 of the gain under the home-sale rules.
- Defer the remaining gain by exchanging into replacement rental or investment property.
Cash you receive in the exchange is first applied against the excluded gain, so you may be able to take out some cash without tax and still defer the rest.
A simple example
A married couple bought their home years ago for $200,000. It’s now worth $1,000,000, a gain of about $800,000. Selling outright, they exclude $500,000 and pay tax on $300,000.
Instead, they move out, rent the home for two years, and then sell it through a 1031 exchange while they still meet the two-out-of-five-years residence test. They exclude $500,000 of the gain and defer the remaining gain into a replacement rental. (Any depreciation they claimed during the rental years is handled separately; see below.)
The timing rules
- The exclusion clock. You need two years of residence in the five years before the sale. In practice, the sale needs to close within three years after you move out.
- Investment intent. The home needs to be a genuine rental before the exchange. There’s no fixed minimum, but many advisers suggest renting it at fair market rent for at least one to two years.
- The exchange deadlines still apply: 45 days to identify replacement property and 180 days to close, with sale proceeds held by a qualified intermediary.
Depreciation while it’s a rental
You must depreciate the home while it’s rented. Gain equal to that depreciation can’t be excluded under the home-sale rules; normally it’s taxed at up to 25%. In a combined exchange, that portion can be deferred along with the rest of the gain.
The reverse: moving into a former rental
If you move into a property that was a rental and later sell it, the exclusion is reduced for periods of “nonqualified use” (rental years before it became your home, after 2008). A replacement property acquired in a 1031 exchange also has to be held five years before the home-sale exclusion can apply to it.
Plan it before you move out
This strategy works best when it’s planned before you leave the home. We can estimate the tax with and without the exchange so you can decide whether renting the home first is worth it.
Questions about your situation?
Call us at 303-734-1040 or email 1040@taxshop.tax. We’re an independent Colorado tax practice in Lone Tree, serving clients since 1969.