Among the tax benefits available to homeowners, one of the most useful is the “principal residence exclusion” provided by Internal Revenue Code (IRC) section 121, which allows homeowners to exclude a certain portion of their capital gains when they sell their primary residence. The logic underlying this section is that those who sell their primary residence will nearly always turn around and purchase another residence. The law has given homeowners a tax break in this situation to help them purchase a replacement home.

What few CPAs, tax attorneys, and other professionals realize is that there is a loophole in the application of IRC section 121 regarding scenarios involving nonqualified use, which can affect the availability of the exclusion. Bringing this loophole to the attention of clients with converted property may be very useful, although using it may require a longer dwelling period or a minimum selling price. This article discusses the basics of IRC section 121, the mechanics of the nonqualified use ratio loophole, and how clients can use section 121(b)(5)(C)(ii)(I) to extract the maximum allowable exclusion even in cases of non-qualified use.

The Basics

The core of IRC section 121 is fairly simple. Individual homeowners can exclude from gross income up to $250,000 of gain ($500,000 for certain married couples filing jointly) provided that they satisfy the ownership requirements. These are stated in section 121(a): homeowners must dwell in the residence for a minimum of two years during the most recent five-year period. The two years need not be consecutive. The exclusion is also subject to other limitations, such as the rule that the exclusion is only available once every two years; this rule is in place to prevent abusive tax avoidance.

The Nonqualified Use Ratio

Another limitation to the exclusion under IRC section 121 relates to “nonqualified use,” which refers to any use other than as a primary dwelling place. In the event that a homeowner wants to use section 121 on a property that has nonqualified use, the exclusion will be modified by the nonqualified use ratio. This ratio, found under section 121(b)(5)(B), is based on the time allocated to nonqualified use (the numerator) and the total time of ownership (the denominator). The resulting portion of the gain is not eligible for exclusion.

Assume a taxpayer purchases a property and uses it for business purposes for three years. The taxpayer then moves into the property, converting it to a primary residence, and then decides to sell after a period of two years. In this scenario, the nonqualified use ratio would apply when IRC section 121 is invoked, because the taxpayer has nonqualified use at the initial stage of ownership. In this particular case, three-fifths of the gain would not be eligible for exclusion, because three of the five years of ownership were allocated to non-qualified use. In many cases, the nonqualified use ratio can dramatically limit the amount of gain eligible for exclusion. Suppose that this same taxpayer generated a $300,000 gain when the property was sold after the fifth year of ownership; instead of being able to eliminate the full $250,000 (assuming the taxpayer is unmarried), the taxpayer would only be able to eliminate two-fifths of the gain, or $120,000. In this case, the nonqualified use ratio reduces the available exclusion to less than half of its full potential.

In certain situations, the way that the rules are written permits the maximum exclusion even in cases of nonqualified use.

Obtaining the Maximum Exclusion with Nonqualified Use

Many people who are aware of IRC section 121—including many specialists—may assume that nonqualified use necessarily means that only a part of the exclusion will be available. This is a very logical assumption; in fact, there is a very high probability that the nonqualified use rules were conceived with the intention of reducing the amount of the exclusion in all instances of nonqualified use. In certain situations, however, the way that the rules are written permits the maximum exclusion even in cases of nonqualified use. As long as the nonqualified use ratio allocates a sufficiently small amount, the maximum exclusion can still be taken.

Consider the following scenario: A taxpayer buys a property and uses it as investment real estate for five years, then converts it to a primary residence and lives there for three years. At the end of the eighth year of ownership, the taxpayer sells the property and invokes IRC section 121. The non-qualified use ratio would be five-eighths, because five out of a total of eight years were used for investment purposes. Further assume that the amount of gain is $700,000 when the property closes; assuming the taxpayer is an individual, that taxpayer can still exclude the maximum allowable amount. Multiplying this amount by five-eighths results in $437,500 of gain that is not excludable as a result of nonqualified use. This means that $262,500 is available for exclusion, which would mean that this taxpayer would be able to exclude the individual maximum of $250,000.

As can be seen above, the nonqualified use ratio does not actually reduce the exclusion itself, but only the gain that is eligible for exclusion. From this, tax advisors can extrapolate a similar outcome as that described above in any number of other hypothetical instances and advise individuals on how to extract the maximum exclusion in a given situation. This may involve counseling a homeowner to prolong the dwelling period prior to selling in order to reduce the total amount of gain allocated to nonqualified use, or to accept a minimum price on a given property in order to ensure that the gain exceeds a certain threshold. The specific advice given will depend on the facts of a given case.

Again, these rules were likely written on the presumption that the exclusion would in fact be reduced in nearly all instances. Even though the nonqualified use ratio does not expressly limit the exclusion itself, the underlying intention of these rules is to limit it. This is sensible, because nonqualified use should be taken into account when the IRC section 121 exclusion is applied. Converted property touches on the substance of the transaction; it relates to how the property was actually treated by the taxpayer during the term of ownership. The substance of a transaction is also highly important within the context of determining tax benefits. If the intention of the rules was to limit or reduce the exclusion, then they should have been written to directly limit the exclusion, rather than the gain eligible to be excluded. This would be consistent (and arguably more logical) with the intention underlying the rules.

Another Loophole

Another opportunity to creatively use the rules to yield the maximum exclusion lies with the exception under section 121(b)(5)(C)(ii)(I). This exception applies to nonqualified use that occurs after the last date the property was used as a primary residence. It reads as follows: “The term ‘period of nonqualified use’ does not include any portion of the five-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse.”

This means that, if a taxpayer initially owns the property as a primary residence, but then converts it to another use, the nonqualified use that occurs after the conversion will not be considered a “period of nonqualified use” for tax purposes. This exception can be used in different ways to produce a more beneficial tax outcome. For example, a taxpayer could be counseled to dwell in a particular property before converting it to another, non-qualified use. Or, in the event that a taxpayer initially has nonqualified use and converts to a primary residence, the taxpayer could be counseled to convert the property for additional nonqualified use after establishing the two-year dwelling requirement in order to positively affect the nonqualified use ratio.

A Situational Benefit

Ultimately, the facts and circumstances of an individual taxpayer’s case will determine whether or not they can use the IRC section 121 loophole to its greatest effect. CPAs should familiarize themselves with the particulars of section 121 and fully investigate its possible applications when presented with home sale transactions that involve capital gains and nonqualified use.

Jorgen Olson, JD is a writer and tax attorney in Seattle, Wash.