The Exclusion of Gain on the Sale of a Principal Residence, The New Restriction for Nonqualified Use

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Theodore D. Peyser, Esq.
Roberts & Holland LLP, Washington, DC and New York, NY

The §121 exclusion for up to $250,000 ($500,000 if married filing a joint return) of gain on the sale of a principal residence is now restricted on account of any nonqualified use of the dwelling. This restriction was one of the revenue offsets in the Housing and Economic Recovery Act of 2008, P. L. 110-289, and is contained in §121(b)(4).1 This new subsection provides that the exclusion will not apply to so much of the gain from the sale or exchange of property after December 31, 2008, as is allocated to periods of nonqualified use. Congress believed that application of the §121 exclusion to gain attributable to periods of use prior to a home's use as a principal residence was not consistent with the purpose of encouraging home ownership.2

Gain Allocated to Periods of Nonqualified Use

A period of nonqualified use is any period during which the property is not used as the principal residence of the taxpayer or the taxpayer's spouse or former spouse, excluding the portion of any period preceding January 1, 2009.3 Accordingly, a period of nonqualified use is one during which the property is rented to a third party, used by the taxpayer as a vacation home, or even left unoccupied. To derive gain allocated to periods of nonqualified use, one must multiply the gain by a fraction, the sum of the periods of nonqualified use during taxpayer's ownership over the period of taxpayer's ownership.

Exceptions to the Definition of Periods of Nonqualified Use

Periods of nonqualified use do not include:

1. That portion of the 5-year period ending on the date of sale which is after the last date that the property was used as the principal residence of the taxpayer or the taxpayer's spouse (so that periods of rental or vacancy which follow two years of principal residence will not count);

2. Any period up to 10 years during which the taxpayer or the taxpayer's spouse is serving on qualified official extended duty as a member of the uniformed services or the Foreign Service or as an employee of the intelligence community. This type of duty is defined in §121(d)(9)(C) as duty for a period in excess of 90 days or for an extended period at a duty station at least 50 miles from the principal residence or while residing in Government quarters.

3. Any other period of temporary absence not to exceed two years due to change of employment, health conditions, or other unforeseen circumstances as may be specified by the Secretary (so one year of temporary absence of this character occurring after a year of principal residence and before a second year of principal residence will not count). The phrase “change of employment, health conditions, or other unforeseen circumstances” also appears in §121(c)(2)(B) and these terms are defined in Regs. §1.121-3.

Coordination with Recognition of Gain Attributable to Depreciation

The exclusion provision of §121(b)(4) does not apply to gain attributable to depreciation attributable to periods after May 6, 1997. §121(d)(6). The new exclusion of gain allocated to nonqualified use is to be applied after application of (d)(6) and without regard to any gain to which (d)(6) applies. §121(b)(4)(D).


An individual T buys a property on January 1, 2009, for $400,000 and uses it as a rental property for two years, claiming $20,000 of depreciation deductions. On January 1, 2011, T converts the property to his principal residence. On January 1, 2013, T moves out, and on January 2014, T sells the property for $700,000. For 2014, T includes in income the $20,000 of the gain attributable to the depreciation deductions. Of the remaining $300,000 in gain, 40% (2 years divided by 5 years) or $120,000 is allocated to nonqualified use and is not eligible for the exclusion. Since the remaining $180,000 gain is less than the maximum $250,000 exclusion, $180,000 of the gain is excluded from income.

An individual B buys a principal residence on January 1, 2009, for $400,000 and moves out on January 1, 2019. He sells the property on December 1, 2021, for $600,000. He can exclude the entire $200,000 gain because under §121(b)(4)(C)(ii)(I) periods of nonqualified use after the last qualified use do not constitute nonqualified use.4

A married couple (C and D) expecting a first child purchases a new home on January 1, 2010. To their surprise, they have triplets and on account of this unexpected event, they wait 6 months until July 1, 2010, to make the newly purchased property their principal residence. They sell this residence on January 1, 2015, realizing a gain of $100,000. They can probably exclude the entire $100,000 on the ground that the 6-month period January 1 through July 1, 2010, was not a period of nonqualified use on the ground that is was attributable to the unforeseen circumstance of multiple births.5

The newly effective restriction for nonqualified use will discourage taxpayers from buying a dwelling for rental purposes, with the idea of later making it the principal residence to seek a $250,000 (or $500,000 for joint returns) exclusion. A purchase followed by 3 years of rental and then 2 years as a principal residence followed by a sale will now produce a 60% (3/5) reduction in the gain which might be excluded under §121.

For more information, in the Tax Management Portfolios, see Edwards, 594 T.M., Tax Implications of Home Ownership, and in Tax Practice Series, see ¶1530, Nonrecognition Transactions Upon Sale of Principal Residence and ¶2460, Vacation Home and Home Office Deductions.

1 §3092(a) of P.L. 110-289 added to §121(b) subsection 4, entitled “EXCLUSION OF GAIN ALLOCATED TO NONQUALIFIED USE.” Eight months earlier, §7 of P.L. 110-142 added to §121(b) a subsection 4, entitled “SPECIAL RULE FOR CERTAIN SALES BY SURVIVING SPOUSES.” To correct this mistake in numbering, at some point, Congress is likely to make the Exclusion provision subsection 5.

2 H.R. 110-356 on the Mortgage Forgiveness Debt Relief Act of 2007 (Oct. 1, 2007), p. 9.

3 Whether a property is used by the taxpayer as his principal residence depends upon the facts and circumstances. If the taxpayer alternates between two residences, the place where he spends the majority of his time will ordinarily be his principal residence. See Regs. §1.121-1(b).

4 See Joint Committee Summary of P.L. 110-289.

5 See Regs. §1.121-3(e)(2)(iii)(E) and Example 4. It seems likely that the IRS will make the rules in this regulation applicable to §121(b)(4)(C)(ii)(III).

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