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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.
Speaker: 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 Kalady, I'm
your host, and I am so excited
that you've decided to join me.
Microphone (Shure MV7)-1: 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.
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 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.
And maybe this episode will also
remind you to check the cutoff time
for your egg McMuffin this weekend.
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.
Microphone (Shure MV7)-3: 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.
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
$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.
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 that primary home.
Is used for something other
than being a primary home.
Those years are considered.
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 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.
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.
Microphone (Shure MV7)-4: 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
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.
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.
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 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.
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.
Microphone (Shure MV7)-5: 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 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.
There's going to be unrecaptured
1250 depreciation or some
depreciation recapture.
But otherwise.
That circumstance allows
for a full 1 21 exclusion.
The fact that it was a rental when
it was sold, doesn't impede that as
long as those requirements were met
For the two years of minimum occupancy
and then no more than three years
of rental use, they are good to go.
Next circumstance.
We have a taxpayer who owned an occupy.
A primary home that they
purchased for 750 days.
Just like the last example
we know we're good.
We have more than two years.
The taxpayer then moves out and
rents this property for 1500 days.
Because they have now rented it.
For more than three years,
they no longer have.
Two years of qualifying
minimum use required.
Within that five-year lookback window.
Because they no longer have two
years within the five-year window.
They now qualify for $0 of exclusion.
There is no part of the
1 21 exclusion anymore.
They have rented it for too long.
And they lost that qualifying time.
So again, Small timing differences,
huge impact on the taxable outcome.
The next example.
We have a taxpayer who
purchases a primary home.
And they own and occupy it for 720 days.
So they are just shy
of that two year mark.
They move out and convert it to
a rental for a thousand days.
So they did not rent it for
any more than three years.
However, because they didn't meet.
The core requirement of at least that
730 days of ownership and occupancy.
They would receive.
$0.
Tax-free.
Because they did not hit
that 730 day minimum.
They do not qualify
for the 1 21 exclusion.
And no part of their
sale will be tax-free.
The followup question to this
scenario that I've heard more
than once or seen question online.
As well since they were only short
by 10 days, can the taxpayer.
Moved back in to make up those 10 days.
The answer is maybe.
Let's look at how those potential
scenarios would play out.
So we have the same
starting circumstances.
Taxpayer purchases a primary home.
They own and occupy it for 720 days.
So they're still shy
of the 730 day minimum.
They move out and rented
for a thousand days.
So they have rented it
for less than three years.
And then.
The taxpayer moves back
into the home for 60 days.
So now we have more than 730 days.
Of primary use in the last five years.
We also have.
A total of 1,780 days of total ownership.
So we haven't exceeded that
five-year lookback window.
So we now have a combined total.
Of 780 days of primary
use the original seven 20.
And then the 60 more days
from when they moved back in.
So we have more than two years.
However.
We now run into a caveat.
If you remember from the beginning
of the episode, If there is use
of a home where it's not being
used as a primary residence.
It is non-qualified use.
And the gain related to that
amount of time will be taxable.
The exception to that.
Is any rental use after.
The most recent.
Qualifying use as a primary resident.
In this situation, we have more
than 730 days of primary use.
However, the rental use that.
1000 days of rental use.
Occurred before.
The most recent use of the
home as a primary residence.
That rental use happened.
Before they moved back in to get
that extra 60 days they needed.
To hit the full two years.
So now what happens?
Now, what we have is a prorated gain.
So because they do meet the requirements.
This taxpayer does qualify now that they
have more than that two years out of five.
They qualify for the 1 21 exclusion.
However the time that it was
non-qualified the time of that thousand
days of rental use in the middle.
The gain related to that 1000 days.
Cannot be excluded.
That portion of the gain will be taxable.
So 1000 days.
Out of the total ownership of 1,780.
Is going to be non-qualified use.
What that means is when they sell.
56% of the game.
We'll be taxable and only that remaining
44% would qualify for the 1 21 exclusion.
But.
All things considered.
Are they still ending
up in a better scenario?
Than if they had not
moved back in for 60 days.
Absolutely.
If they hadn't moved back in for 60 days.
They wouldn't have the 730 day
minimum requirement for occupancy.
Meaning a hundred percent of their
gain would have been taxable.
So again, Slight differences
in the way it plays out.
I can have large impacts
on the taxable outcome.
Let's look at the next example.
We have a taxpayer who
purchases a primary home.
They own and occupy it for 720 days.
So we're just shy of that two year mark.
They move out and they
rent it for 1100 days.
In this scenario, can the taxpayer moved
back in just like the last example?
Can they move back in to
get that 10 more days?
They need.
To meet the two year requirement.
They need 730 days.
They are 10 days short.
In this case.
The answer is no.
The difference here.
Is the 100 additional days of rental use.
Microphone (Shure MV7)-6: If we are
starting out with 720 days of primary use.
And we have 1100 days of rental use.
If we add 10 more days, we end up
being beyond the 1,825 day window
for that five-year look back.
If we have 720 days.
Plus 1100 days, we're already at 1,820.
So if the taxpayer were to move back in
for 10 more to get above the 730 days.
They have now also lapsed
that five-year look back.
So in this scenario, because there was
an extra a hundred days of rental use
before they decided to move back in.
To reach that 730 day minimum.
They would fall out of the required
timeframe And they would receive.
No amount of 1 21 exclusion,
their gain would be fully taxable.
Microphone (Shure MV7)-7: Again,
I can't reiterate this enough.
Super small nuances when it
comes to this code section.
Can have dramatically different outcomes.
I know this is a little bit of a hard
episode to follow along, listening to,
and at some point I will put this all into
something more visual, because I think
it'll be easier to follow along with.
I just really want to get some
of these really common, but
slightly varied examples out there.
'cause I don't think people realize how
quickly something can go from no tax being
paid on a half million dollars to the
entire half million dollars being taxable.
Let's get into the last
two examples I have.
And we're going to try to end
things on a more positive note.
So for this example, The taxpayer
purchases that primary home they
own and occupy it for 720 days.
So they are just shy
of that two year mark.
They move out.
And rent the home for 700 days.
The reason they are renting the
home for that 700 day period.
Is because the taxpayer is
temporarily in another state
to receive medical treatment.
So while they're in that other
state, they're renting the home.
When they are done with their treatment.
They move back and they live in the home
for 60 days before they decide to sell.
Again, if we think back to the
very beginning of the episode.
The third exclusion to non-qualified use.
Is a temporary absence of
no more than two years.
Due to a health reason or a work-related
reason or a unforeseen circumstance.
So in this scenario, even
though we have 700 days of
rental use better in the middle.
I have two different
primary use timeframes.
Because it is less than
two years of an absence.
And it is due to a health-related reason.
Those 700 days.
Do not count as non-qualified use.
This means that this taxpayer
now has over 730 days.
Of primary use.
So they meet that two year requirement.
And they don't have any non-qualified
use because it met one of the exceptions
because it was a temporary absence.
So when this taxpayer goes to sell
this home, They would still qualify
for their full 1 21 exclusion.
Another reason.
I like putting these
unique examples out there.
Is for the tax professionals listening.
It's really easy to assume that if someone
has these gaps where a property is rented,
or if they have to sell it before the
two year mark, et cetera, to default to
assuming those will create taxable events.
But there's quite a few nuances
where that might not be the case.
So the example we just covered was
really similar to an earlier one.
Where, because the taxpayer had lived in
the home for just shy of two years, then
they rented it for less than three years.
And then they moved back in
so that they could hit that
two year minimum of occupancy.
In that case they had non-qualified
use making the gain for
those middle years taxable.
In this case.
Same situation, but because the
absence, when it was rented, Was
created due to a temporary qualifying
absence for a medical reason.
That time is not non-qualified use.
And in this circumstance, they would
still receive the full 1 21 exclusion.
Final example, and I promise
this is as tricky as we will get.
We have a taxpayer who
purchases a primary home.
And they own and occupy it for 750 days.
So they've hit.
At least 730 days, they have
met that two year requirement.
This taxpayer moves out and
rents the home for 700 days.
Because they are at another
state due to medical treatment.
So while they're out of state, For
this medical related temporary absence.
They are renting the home.
Because that is a medical related
absence of no more than two years.
That does not qualify
for non-qualified use.
We are all good there.
After their medical treatment, the
taxpayer moves back into the house.
And they occupy it for a thousand days.
Because they have now reached
a thousand days in the most
recent five-year lookback window.
They have at least two years again.
We're still good.
We have not timed out from going
beyond a five-year lookback.
And we have at least two years of primary
use within the most recent five years.
And that prior 700 days of rental use.
Is also not counting against them because
it was a qualified, temporary absence.
So the current fact pattern is.
Little more than two years of primary use.
Less than two years of rental use,
but it was due to an exception.
So it does not create, non-qualified use.
And then we have over
two years of primary use.
Again, they moved back
in for a thousand days.
After living in the home for that
thousand days after they moved back in.
They decide to rent it.
They move out and they rent
the home for a thousand days.
Because this period of rental use.
Is no more than three
years within the last five.
And this period of rental use occurred.
After their most recent period
of qualifying primary use.
It is also an exception
to non-qualified use.
Okay.
So this is an example where
a taxpayer lived in a primary
home for a couple of years.
Rented that home for a couple of years.
Moved back in for a few years.
Rented it for a few years.
And even with all of those
circumstances coming into play.
When this taxpayer sells, they will
still receive their full 1 21 exclusion.
Because both of the periods of rental use.
Meet an exception.
To being defined as non-qualified use.
So this taxpayer in this circumstance
would have the full 1 21 exclusion.
And the only tax they would have would
be paying back any depreciation from
during those rental years, So I know
today's episode was kind of a lot.
It might be something you have
to listen to more than once.
I know it's not the best as an
audible experience, and I hope
to have it in something a little
more visual for you guys soon.
But hopefully it got some
wheels turning for you.
Or maybe there's someone out there who
got to hear this, and it is stopping
you from moving too soon or selling
too late, whatever the circumstances.
And overall, I just hope it's
made people a little more aware.
Of how these tiny changes in the
timing and the circumstances in
connection to the 1 21 exclusion.
Can make all of the difference.
Between something being
completely tax-free.
Partially taxable or completely taxable.
Again, think back to that egg McMuffin
you're dreaming of on a Sunday morning.
Showing up at the drive-thru
10 minutes too late.
Multiply that feeling by a thousand.
That's how it would feel to barely miss.
All of this money being tax-free.
Because you miscalculated the timing.
That's what I have for you guys today.
I want to hear your thoughts.
If you have run into a situation
related to a 1 21 exclusion, if you
know someone that you think is going
to benefit from realizing these
specific timelines, they need to meet.
If there's any story you have in
connection to selling a primary
home and having something unexpected
happen, I would love to hear about it.
Find me on social com.
Add me on Instagram at R E tax strategist.
Microphone (Shure MV7)-8: I've
always, I hope that you gained
some value from today's episode.
And I just want to take a second
to say how appreciative I am to
everyone who has been listening to
the show and shared their kind words.
Left a good review or
shared it with friends.
So you guys mean the world to me.
If there is a topic that you
have questions on or that you
would like to hear me cover.
Again, find me on social media,
Ari tech strategist on Instagram.
Send me a message.
Share the topic you
want to hear more about.
And as always, I will
talk to you next week.
Mhm.