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Hey there, fellow real estate investors, FIRE enthusiasts, and tax aficionados! Welcome to "Real Estate is Taxing" – your go-to weekly podcast for all things real estate taxes, hosted by Natalie Kolodij, EA- Real Estate Tax Strategist and dry humor extraordinaire.
Each week, we're breaking down complex tax topics into bite-sized, understandable explanations, with no regard for how many obscure references it takes to get there.
Hey everyone.
And welcome to today's episode.
If you have heard me speak somewhere,
or if you followed me on social media.
Then you will know that today's
episode topic is something I
am incredibly passionate about.
The reason being is that this
is something that impacts an
incredible amount of Americans.
Whether or not, they are
a real estate investor.
what I want to talk to you guys
about today is the 1 21 exclusion
or the primary home sale exclusion.
So I want to start by giving you
guys a brief recap on what this is.
And then I want to walk through
the five most common mistakes.
I see.
That could be costing you thousands of
dollars in tax, if either you or your
tax professional don't understand this.
So starting with the basics.
The 1 21 exclusion or
primary home sale exclusion.
Says that if you own and occupy your
primary home for two of the most recent
five years, when you sell it, you get
to exclude a large amount of the gain.
It's important to note that this is
actually based on the number of days.
So it's not based on a calendar year
or a ballpark based on the month
you moved in and the month you sold.
It is the literal number of
days that you own and occupy.
What this means is that when
you're hearing two of five years,
What you need to do if you are
considering selling a primary home.
Is that you need to look at the day
you bought it and moved in and the day
you would be selling it and move out.
It is actually 730 days out of 1,825 days.
So if you have a qualifying move in
and that becomes your home on June 1st.
And then you go to sell it two
years later, but you sell it on.
May 15th, you will not
reach that exclusion.
I have seen people.
I think that they are going to have
their gain fully qualify under this.
And then literally miss it because they
moved out and sold the primary home.
A couple of weeks too soon.
You do not want to make that mistake.
So ensure that if you are planning
to sell a home that you have used
as your primary, that you nail
that down to the literal day.
Another common thing that I'm not
sure people are aware of, but is
really important for you to know.
Is, we often also hear
that this exclusion, right.
You own an occupy for two out of five
years, which we've just learned is
actually 730 days out of 1825 days.
Gets you $250,000 of gain.
Tax-free.
If you're single or
500,000, if you're married.
That is typically the case.
But something people don't consider is
it's not technically related to being
single or married most of the time.
Each legal owner who meets the qualifying
terms of ownership and occupancy.
Qualifies for their
own $250,000 exclusion.
What does this mean?
This means if you and
two of your siblings.
Buy a house together and live together
in that house for more than two years.
When you go to sell it.
If your gain is above $500,000, you
can still exclude it because each one
of you has your own 1 21 exclusion.
So in theory, If three people all
legally own a primary residence
together, and they all use it as
their primary residence for two years.
When they go to sell it up to
750,000 of gain could be excluded.
That is because the 250,000
excludable gain is per legal owner.
So, those are kind of the basics.
Of the 1 21 exclusion.
You own an occupy a home for
two out of five years, but
the caveat is it's to the day.
Be cautious.
And you get $250,000 of
excludable gain per legal owner.
So you can actually exclude.
More than 500,000.
This is a tax provision.
That is incredibly powerful, very few
ways that you can make a half million
dollars and not pay any tax on it.
In conjunction with that.
There's a lot of nuance that relates
to this section of the tax code.
And there's a lot of pieces
that are often misunderstood.
What I'm going to dive into now.
Are the five most common mistakes.
I see.
Related to the 1 21 exclusion.
There are absolutely
more mistakes than this.
There are absolutely more ways I've seen
this screwed up, but these are the five
that you need to know to make sure that
you are not paying tax for no reason.
And most of these mistakes I have
seen from both tax professionals.
And taxpayers.
So some professionals even get these mixed
up, so we're going to dive into it and
make sure, you know, Every little detail
to avoid these five most common mistakes.
The first common mistake.
Or the first common misunderstanding.
Is that if after you use your home as
a primary home for at least two years,
If you convert that to a rental, you
move out, you decided to rent the house.
That you by default
have non-qualified use.
The tax code defines non-qualified
use as any time that house is not
used as your qualified primary home.
So it is true that if you lived in it for
two years and then changed it to a rental.
Those years when you're renting it.
It's technically not your primary home.
It wouldn't be your qualified main home.
However, there is an
exception in the tax code.
There's all.
There's so many exceptions.
So there's an exception in this
code provision that says any
time the home is not being used
as the primary residential home.
Um, it's non-qualified use.
Accept.
If that time occurs.
After the most recent time that
you used it as your primary home.
What does this mean?
So if we think back to the
basics, To sell your primary home.
Tax-free.
You have to own and occupy for
two of the most recent five years.
What that effectively means
is the day you go to sell.
There's like a, five-year
look back right there.
Looking back five years.
And as long as it, any time during
that chunk, you had, um, owned and
occupied it as your primary home.
There's a good chance.
You can qualify.
Because this exception.
His time after your most recent use as
a primary with this means is that if you
have lived in this home for two or more
years, And you convert it to a rental.
You have up to three years to
sell where you can still receive
your full 1 21 exclusion.
Because it is a five-year look back.
You have lived in at least two.
And there's that exception that
any time after your most recent use
does not count as non-qualified.
This is something I have seen
multiple tax professionals get wrong.
So if you live in your primary
home, You convert it to a rental.
And then you sell it
within a three-year window.
You still qualify for the entire 1
21 exclusion there's no, prorating,
there's no part that's non-qualified
use for those years are taxable.
You qualify for the full exclusion.
The only thing you would need to pay.
Is you pay back that
unrecaptured 1250 depreciation.
So your straight line depreciation,
you have to take on the house.
For those years, it was a rental.
But.
There's not non-qualified use.
I see this mixed up all the time.
And it's resulting in taxpayers paying
tax when they literally do not have to.
So that is my first warning.
This is the first thing that I
think is so important to understand.
The next mistake or the next common error
is almost the inverse of the first one.
This is the concept where
people seem to have.
They've gotten it in their brains,
that the whole gist of this code
is well, two out of five years,
you get to sell it tax free.
Right?
Two out of five years.
That's all you need.
That's all you need.
So I've seen a lot of people think.
That if they've had a rental for.
20 years.
And it has a ton of
gain built into it now.
Right?
If they sold it today that have a lot of
gain, the value has gone up tremendously.
And they think, oh, well I will
just move into it for two years.
And then I meet that.
That criteria.
That 1 21, 2 out of five year rule,
and now I can sell it tax free.
That's my plan.
This is the circumstance where
you do have non-qualified use.
Again, non-qualified use.
This became a thing in 2009.
So any houses from prior to
that, any rental time prior
to that, we don't look at.
But after January of 2009, any
time a house was a rental before
the time it was your primary.
That is non-qualified use.
So what this means is that if you
owned and rented this house for 20
years, And then you move into it
for, to thinking you can exclude your
full gain using the 1 21 exclusion.
That's not the case.
When there's non-qualified use.
What happens then is the gain that is
proportionate to the amount of years.
It wasn't your qualified primary.
The gain related to that number
of years is in fact taxable.
So in this example, 20 out of
22 years worth of the gain.
Is going to be taxable.
It cannot be excluded under the 1 21.
Something else that people.
Kind of misunderstand what this.
Is there thought, is that okay?
Well, of those two years left
that qualify for the 1 21.
They can exclude a smaller amount of gain.
Like it reduces the gain.
That's not the case either.
They still qualify for that
full amount of $250,000.
It's just that the amount of overall gain.
Would have to be tremendous.
For two years worth of it to be under
$250,000 or to get up to that point.
So they can still exclude up
to $250,000 worth of gain.
As long as the portion of gain
related to only two years is $250,000.
But this is where non-qualified use.
Does come in.
So if you have had a rental property for
years and years and years, and you think
to yourself that you can move into it.
Live there for a couple
years and get to sell it.
Tax-free.
I will save you the you hall fees.
Don't do this, not going to help now.
If you move into it, right?
Like say, you've already made
this mistake, you're in your
car, you're listening to this.
And you're like, ah, crap.
Um, it does get better the longer you live
in it, because this is a ratio, right.
So if you've owned it and rented
it for 20 years, and then you move
in and live in it for 20 years.
Well, now half of the gain when you sell.
Qualifies for the 1 21 exclusion.
But just no.
The recap on non-qualified use.
If it's your primary first and you
rented for no more than three years.
There is no non-qualified use, you can
sell it and get the full 1 21 exclusion.
You just pay back depreciation.
If it starts as a rental or
starts as a business use property.
And then you move into it.
There will always be non-qualified use.
That means the number of years.
That it was rented out of the
total number of years of ownership.
That portion of the gain is
always going to be taxable.
The third common mistake that I see all
the time related to the 1 21 exclusion.
Is understanding when and when
you do not have to prorate it.
In relation to a house hack.
Now.
When we talk about house hacking,
this term gets used interchangeably.
For someone who is either.
Living in a single family home and
they essentially have roommates, right?
You're living in your primary bedroom.
You renting out the spare two bedrooms.
This term also gets used for
the circumstance where maybe you
bought a duplex or a fourplex.
You're living in one unit, you're
renting out the other three.
For all intents and purposes.
Using the same term for both is, is fine.
Right?
We're doing kind of the
same thing for taxes.
There's a much bigger
difference between the two.
Like I saying earlier, and a
lot of the tax code, there's
often these weird exceptions.
They love to throw something in there.
Uh, just, just as a little test.
So, this is where another
exception comes into play.
Normally with the 1 21 exclusion.
It applies only to your dwelling unit.
This is literally within the four walls
of a separate unit that you occupy.
So if you are house hacking, And you are
house hacking a fourplex and you live in
one unit and you're renting three units.
When you go to sell.
Only one fourth of the gain.
Assuming all of the
units are the same size.
Only one fourth of the gain.
Will you be able to exclude
under the 1 21 exclusion?
A lot of people think because they're
living in the overall building, they
can sell it and exclude the whole thing.
It's not the case.
It is literally your only, like literally
only your unit, your legal dwelling unit.
So the flip side to
this and the exception.
Where we do not need.
To prorate where you can
still get the full 1 21.
Is if this space you are renting.
Is within your telling unit.
So in the circumstance where
you're the house hacker who is
renting your spare bedrooms.
When you go to sell that house?
You will still qualify for
the full 1 21 exclusion.
As long as the space being rented is
within the same legal dwelling unit
that you are occupying as your primary.
It still qualifies for the full exclusion.
Again, the only thing you
pay back is the depreciation.
So two strategies.
Same name.
We call on the same thing.
We talk about them interchangeably.
But it's important to be very aware that
whether you're renting rooms in your
house, Or whether you are living in one
unit out of like a duplex or a four unit.
The impact is going to be different.
Renting rooms in your house,
you can still qualify for that
full tax-free primary exclusion.
If you are living in a
small multiunit property.
Only your legal dwelling unit,
only the proportion of gain.
Proportionate to your unit square footage
out of the total of that whole property.
Only that piece is going to be excludable.
Now the other three units.
Those will all be taxable when you sell.
And you can utilize a 10 31
exchange for the gain related to
those three, if you would like.
But that's a whole different episode.
But just know that when you're
looking at house hacking the type
of property, your house hacking is
going to impact what you can exclude
under the primary home sale exclusion.
When you sell.
So just something to keep in mind,
if that is part of your strategy.
If your overall thought process is that
you're not keeping this house long term.
If you're planning to do somewhat
of a live and fix and flip
while you're house hacking.
Very different impact.
On if you are renting rooms in
a house versus one unit or multi
units in a small multi-family.
The.
Next item related to 1 21 exclusion.
That.
I want to talk about for a minute,
because I think a lot of people.
Also don't think about this one.
There's a handful of kind of common
statements about most things.
But on this tax code, right?
It's two out of five years.
That's what everyone hears.
And the other thing people say in
relation to that, Is that you can
only use it once every two years.
And that makes sense
on the surface, right?
If you have to live in something for
two years, Then you, how could you do
this more often than every two years?
Well, there again is an exception,
just like with a lot of other things.
If you haven't lived in your primary home.
For that entire two years yet.
If you've lived in it for say one
year, And something comes up that
requires you to move and sell.
And it's an unforeseen circumstance.
If you have to move
because of a job related.
Purpose.
If your job relocates
you across the country.
Or if there's a medical reason, if you
have to move to a different climate,
because your doctor says you have to,
or if you're moving for treatment or
if it's just something unforeseen.
One of my favorite cases about this was
a couple where they became pregnant and
they had just bought a condo and then
they ended up having like triplets.
And so that was an unforeseen
circumstance because the court was
like, sure, this 500 square foot condo
is not designed to house five people.
We get that.
So if you meet one of these.
Unexpected circumstances.
Like you're not just selling
because you want to you're selling
because something major changed in
life that you hadn't planned for.
Then you are allowed to
use a partial exclusion.
So what this means is that.
If at the time this exclusion comes up,
like if you have occupied it for one year
instead of the full two, And your job
says, we need you across the country.
We're sending you there.
What this means is that instead of the
full amount of a $250,000 exclusion,
if you're a single person you're
going to qualify for half as much.
So you would get $125,000 exclusion.
A lot of people are fairly
familiar with that concept.
And if you're not, it's a good one to know
anytime you're selling a primary home.
Think about why you're selling and
if there's a chance, it falls under
something that you weren't planning for.
You could qualify for this.
If you haven't lived there for two years,
always worth looking at always worth
like digging into it a little more.
So most people are familiar with the idea
that if you have to move before two years,
You can get that prorated exclusion.
And.
You can exclude just a smaller
amount of maximum gain, right?
It doesn't mean your.
Gain.
Is by default, partially taxable.
It just means the total amount of
gain that you can exclude is less.
And it's based on the ratio
of two different things.
There's actually two options for this.
And this is the part people
aren't familiar with.
So what most people are familiar
with is what I just mentioned.
Which is the number of
time you have occupied it.
Out of two years.
Right?
So if you'd been there one
year, you get half as much.
If you'd only been there for
six months, you'd only get a
quarter of the full exclusion.
So it prorates that way.
There's a second test.
You can use.
So you have to use the
smaller of these two tests.
And that is either the number of
months that you've occupied it out of
the two years you were supposed to.
Or you can also use the time since
your most recent 1 21 exclusion.
The reason I mentioned, this is, this
is something I have seen in, correct.
By tax prepares most
commonly, I think they don't.
Um, always realize that there's this
kind of secondary option because we've
had these rules drilled into our heads.
So the core rule is typically you can
only do this once every two years.
Right.
But.
If you are moving.
For an unforeseen reason.
You can essentially have this come up
more than once within a two year window.
Or even twice in the same year.
Let's say.
January of the year, right?
You sell your primary home that you'd
owned unoccupied for years and years.
And you buy a new primary right?
Sell the first one.
You get the full 1 21 exclusion.
It's tax-free all good to go there.
Then in November 11 months later,
Your job says, oops, sorry.
We're shipping you across the country.
And you have to get out there next week.
You weren't planning.
To sell this new house you just bought it.
So, this is a case where you
would technically have two
exclusions in the same tax year.
You would have to reported on your
tax return for that same year.
That first 1 21 exclusion would
be the full amount, right?
That first house you sold
you'd lived in for years.
You get to sell it.
No problem.
The second one.
Qualifies for a reduced exclusion, right?
For 11 out of 24 months.
Worse.
Of an exclusion.
And because you have done a 1 21 exclusion
pretty recently within the same year.
That is the test you're going to use.
So in this case, it would be a look
back to that last most recent exclusion.
A lot of software tells you, you can't do
it because on surface level, you can't.
Unless there's this unforeseen experience.
And then you might have 2, 1 21
exclusions within the same tax year.
But again, Because most software
by default, doesn't just let you
do it as kind of a safeguard.
A lot of people assume they
can't do it and they pay the tax.
If the reason you are selling the
house, the second house, if you've
done a 1 21 exclusion pretty recently.
And now you're having to
sell your newer primary home.
If it falls under one of those
unforeseen circumstances where it's
either job related or medical or
just something you hadn't planned on.
You can indeed.
Exclude the gain on that second property.
It's just going to be a
reduced, maximum limit.
But there are cases where you will have.
Not only more than one within
a two year window, you could
even have 2, 1 21 exclusions.
In the same tax year.
So in summary, if you own and occupy
your primary home for two out of
the most recent five years, Which is
actually 730 days out of 1,825 days.
You get to exclude $250,000
of gain per legal owner.
So per legal owner who
meets that qualification.
And past that for common
mistakes to be cautious of.
Is if you rent your primary
home after you move out of it.
And you rent it for no
more than three years.
You do not have non-qualified use
and you can still qualify for that
full 1 21 exclusion when you sell.
The flip side of that.
If you've had a house that started
as a rental and you decide to
move into it for two years.
That does not get you a tax-free sale
that does not get you the full 1 21.
any of those years, it was not
a primary home before it was.
The gain related to that number
of years will always be taxable.
The exclusion related to rental use.
Different for health hacking.
If it is rooms in your primary
home versus different units and
a small multifamily, you occupy.
If you are renting spare bedrooms and the
same house in which you live as a primary,
you do not have to prorate that gain
the full gain, still qualifies for the 1
21 exclusion and you can sell tax-free.
However, if you are renting.
Three units and a fourplex and
you are living in the fourth.
Then only 25% of your gain would
qualify for the 1 21 exclusion.
And the last note.
Is that you can only do
this once every two years.
Unless you had an unforeseen circumstance.
If there was something you didn't
plan on happening, you're selling for
a reason that you hadn't intended.
Your job moves you.
There's a medical reason.
Something just comes up in life.
Then there's a good chance that
you can qualify for a reduced
amount of maximum exclusion.
Even if you have used the 1 21
exclusion within the past two years.
So I know this is a lot of information.
And if you followed me last year,
I did do a 121 days of 1 21.
Where I posted new content about this
topic specifically for 121 days in a row.
I'm going to do something
similar this year.
So keep an eye out for that.
And again, I want to let you guys
know that before you do anything we
talk about in this show, you should
talk to your tax professional.
Well, I am a tax strategist.
I am not your strategist.
I am so appreciative of
you guys joining me today.
I can remember to subscribe and I
will talk to you again next week.