Sec. 121 Planning Opportunities After the Housing Assistance Tax Act

By Robert B. Cockrum, J.D., CPA William C. Quilliam, Ph.D., CPA

The Housing Assistance Tax Act of 2008 (the Housing Act) implemented major revisions to Sec. 121. 1 The Housing Act provided many tax incentives for the housing market, 2 and it was necessary to counterbalance the $15 billion of tax incentives with a like amount of new tax revenues, which the Sec. 121 revisions are designed to help provide.

The changes to Sec. 121 do not affect the core mechanisms of Sec. 121, but several of the tax planning opportunities that have developed since the 1997 overhaul of Sec. 121 will be eliminated or gradually eliminated. This article discusses the new law changes and how and when those changes affect prior and future planning.

Overview of Sec. 121

Under Sec. 121, taxpayers who sell a principal residence can exclude the capital gain on the sale in certain circumstances. Sec. 121 allows an unlimited number of successive sales of principal personal residences and gives the seller a limited capital gain exclusion per sale (up to $250,000/$500,000 depending on filing status). 3 The section requires ownership/ use of the principal residence for two of five years immediately prior to the sale, 4 and only one principal personal residence sale every two years is allowed. 5

Not only were multiple sales of principal residences allowed under Sec. 121 as it was revised in 1997, but periods of ownership were counted when the property was not in fact used as the taxpayer’s principal personal residence. This allowed significant tax planning opportunities for vacation homes and investment properties. Both the vacation home and investment property planning opportunities are limited by the Housing Act Sec. 121 revisions.

The Housing Act also extended the periods for compliance with Sec. 121 up to 10 years in certain circumstances. These include when certain members of uniformed services or the Foreign Service or employees of the intelligence community are required to move as a result of employment assignments and when taxpayers are affected by changes in employment, health, and other unforeseen circumstances in their lives. 6 All the Housing Act provisions became effective January 1, 2009, regardless of the taxpayer’s tax year end.

Qualified and Nonqualified Holding Periods

The major development introduced by the Housing Act is the segregation of the time a residence is held by a taxpayer into qualified and nonqualified holding periods. 7 For sales of residences after December 31, 2008, the Sec. 121 exclusion of gain will not apply to any gain allocated to a nonqualified holding period. The maximum amount of the Sec. 121 exclusion—$250,000 for single taxpayers or $500,000 for married taxpayers filing jointly—is not affected.

Example 1: B sells a residence with $150,000 long-term capital gain from appreciation over 60 months. During that period, 40 months are deemed to be a qualifying holding period and 20 months constitute a nonqualifying holding period. $100,000 of the gain [$150,000 × (40 ÷ 60)] is eligible for the Sec. 121 exclusion, and $50,000 [$150,000 × (20 ÷ 60)] is not eligible for exclusion and is subject to tax.

If the residence is held for more nonqualified months, the allocation of the gain becomes more weighted to taxable income. In the preceding example, if B holds the residence for an additional 20 months as nonqualifying, the factor becomes 40 ÷ 80, with $75,000 [$150,000 × (40 ÷ 80)] of the gain subject to taxation.

Independent appraisals setting the values at the beginning and ending of the qualifying and nonqualifying periods cannot be used for determining allocable values. The allocation is by month. No specific allocation method is provided by statute; however, a mechanical time period allocation is required. 8 The Joint Committee on Taxation used the month allocation without clarification. It is probable that the months method and the days method used in the partial exclusion regulation will provide a suitable preexisting example. 9

Determining Qualified and Nonqualified Periods

The classification of holding periods as either qualified or nonqualified is critical. Any period that is not a qualified holding period is a nonqualified holding period. Qualified holding periods are defined as:

  • Any holding period prior to January 1, 2009;
  • Any period after January 1, 2009, when the taxpayer uses the residence as his or her principal residence; or
  • Any portion of the five-year period following the taxpayer’s use of the property as the principal residence if the property is sold within that fiveyear period.

Qualified holding periods include time the residence is used as the principal residence by the taxpayer, the taxpayer’s spouse, or the taxpayer’s former spouse. 10

Any temporary absence from the principal residence by reason of employment, health, or unforeseen circumstances not exceeding two years does not count as a nonqualifying period. 11 This is similar to the exemption from the two-year use requirement for similar circumstances, 12 although no specific cross-reference is made. The Housing Act makes it clear that the excused absence from the principal residence counts as a qualified holding period and that the cumulative period(s) cannot exceed two years.

Example 2: D, an individual, buys a property on January 1, 2009, for $400,000 and uses it as rental property for two years, claiming depreciation of $20,000. On January 1, 2011, D converts the property to his principal residence. On January 1, 2013, D moves out. D sells the property for $700,000 on January 1, 2014. 13

Of the total gain of $320,000, $20,000 is treated as ordinary income under the Sec. 1250(b)(3) depreciation recapture rules. 14 The remaining $300,000 capital gain is allocated to qualified and nonqualified holding periods. Of the five years the property was held, only January 1, 2011–January 1, 2014, counts as a qualified holding period. $180,000 of the gain is excluded [$300,000 × (36 ÷ 60)] and $120,000 is subject to taxation [$300,000 × (24 ÷ 60)].

Example 3: F, an individual, buys a principal residence on January 1, 2009, for $400,000. F moves out on January 1, 2019, and on December 1, 2021, sells the property for $600,000.

The entire $200,000 gain on sale is subject to Sec. 121 exclusion because (1) the property is sold within the five-year measurement period for ownership and use, and (2) the sale occurs after the qualified holding period. 15

Tax Planning Changes and Opportunities

A common planning tactic under Sec. 121 has been to buy a vacation home or rental property and at retirement sell the family homestead and move into the vacation home or rental property and convert it to the principal residence. After a two-year waiting period in their newly converted principal residence, the retirees can sell it and apply Sec. 121 to exclude the capital gain. Depreciation recapture will apply if the newly converted principal residence has been depreciated after May 6, 1997. All the capital appreciation on the newly converted principal residence could be used for the Sec. 121 exclusion under the pre-Housing Act law.

It is clear this treatment is not gone; it is just slowly being phased out for those taxpayers who held properties before 2009. For those buying in 2008 there is little benefit, and for those buying in 2009 or later there is no longer any benefit.

With January 1, 2009, being the critical date, the planning around it is important.

  • If a vacation home or rental property is bought after January 1, 2009, nonprincipal residence use is treated as nonqualified use. The time before the property is converted to principal residence cannot later be converted to qualified use.
  • Any holding period of a vacation or rental property before January 1, 2009, is not covered by the new law and is deemed to be a qualified holding period, regardless of type of use.

It is important to recognize that the new law does not change a pre-2009 holding period from qualified to nonqualified. The new law is a gradual conversion for existing owners of vacation homes and rental properties. However, for each nonqualifying period after January 1, 2009, an increasing percentage of the capital gain on sale of the principal residence is allocated away from Sec. 121 to taxable income.

Example 4: H bought a vacation home on January 1, 2005, for $500,000, moved into it on January 1, 2010, and moved out and sold it for $800,000 on December 31, 2012. H’s total gain is $300,000. Her total holding period is 96 months, and her qualified holding period is 84 months. 16

$262,500 [$300,000 × (84 ÷ 96)] of the gain qualifies for the Sec. 121 exclusion. The other $37,500 of gain ($300,000 – $262,500) is nonqualifying holding period gain and does not qualify for the exclusion. In addition, because H is single, her maximum Sec. 121 exclusion is $250,000. Therefore, H’s taxable income from the transaction is $50,000 ($262,500 – $250,000 + $37,500).

If H moved in one year later on January 1, 2011, the qualified holding period fraction would decrease to 72 ÷ 96. The qualified holding period gain decreases from $262,500 to $225,000. The nonqualifying holding period gain increases to $75,000.

Practice tip: The longer the pre-2009 holding period and the sooner the post- 2009 conversion to the principal residence, the better for the taxpayer.

An interesting prospect exists in the current housing market. Potentials for significant nontaxable gains may offer rewarding planning opportunities. While residential markets have experienced significant value declines in the past few years, some vacation home markets have experienced even larger declines. Because the allocation of capital gain between qualified and nonqualified holding periods is proportional without regard to the actual timing of value changes, it is possible to consider a waiting game based on anticipated future appreciation.

Example 5: On January 1, 2004, J purchased a second home in Miami Beach for $500,000 and used it solely as a family retreat. By late 2006, it had appreciated to $900,000, but by mid-2008, the value had dropped to $600,000.

If J expects the property to appreciate to $750,000 by June 30, 2010, he will win the nonqualification/appreciation battle. During the 18 months of the nonqualifying holding period, J will accrue $150,000 of gain. The total gain of $250,000 ($750,000 – $500,000) is allocated 60:78 ($192,308) to the pre-January 1, 2009, qualified holding period, and that amount will not be subject to taxation regardless of filing status. The balance of the gain, $57,692, is taxable. So while J gained $150,000 of appreciation between mid-2008 and June 30, 2010, only $57,692 is allocated to taxable income under the Code’s mechanical proportional formula.

Sec. 121(b)(4)[5](ii)(I) makes it clear that one pre-Housing Act tax planning technique will continue to exist post- Housing Act. Any portion of the five-year period ending on the date the property is sold that is after the last date the property is used as the principal residence of the taxpayer or the taxpayer’s spouse is not considered a period of nonqualified use. 17 This allows a taxpayer who has met the Sec. 121 use and ownership test for at least two years to use the property afterward as a rental property, leave it vacant, or use it as a vacation home for up to 36 months before sale. With proper timing of the sale, the taxpayer earns post-principal residence periods as qualified holding periods even though those same rental property, vacant, or vacation home periods before the property’s use as a principal residence would be nonqualifying holding periods.


Sec. 121 continues to be a powerful tax planning option for many taxpayers for their primary principal residences. The changes implemented by the Housing Act limit some of the advantages in planning the conversion of a rental property/ vacation home to a principal residence and its subsequent sale with the use of the Sec. 121 exclusion. These advantages are not gone. Because of their late addition to the Housing Act, 18 full guidance on the operational rules of these changes to Sec. 121—e.g., the proration method or what constitutes employment/health/ unforeseen circumstances—remains to be supplied.


Robert Cockrum and William Quilliam are both senior lecturers at the University of South Florida in Sarasota, FL. For more information on this article, contact Prof. Cockrum at


1 Housing Assistance Tax Act of 2008, P.L. 110-289.

2 Among the benefi ts are the fi rst-time homebuyer credit, the standard deduction for real estate taxes, and various bond provisions. For an overview of the Housing Act’s provisions, see News Notes, “Housing Act Contains Tax Provisions,” 39 The Tax Adviser 638 (October 2008).

3 Secs. 121(b)(1) and (2).

4 Sec. 121(a).

5 Sec. 121(b)(3).

6 Secs. 121(b)(4)[5](c)(ii)(II) and (III). Note: When Housing Act §3092 added a new paragraph to Sec. 121 on “Exclusions of gain allocated to nonqualified use,” it numbered that paragraph (b)(4). However, a paragraph (b)(4) already existed in Sec. 121. This article will cite the new paragraph (b)(4)added by the Housing Act as “Sec. 121(b)(4)[5].”

7 Sec. 121(b)(4)[5](A).

8 Sec. 121(b) (4)[5](B).

9 Regs. Sec. 1.121-3(g).

10 Sec. 121(b)(4)[5](C)(i).

11 Sec. 121(b)(4)[5](C)(ii)(III).

12 Sec. 121(c)(2). For a discussion, see Cockrum and Cabán-García, “Planning Opportunities with the Sec. 121 Partial Exclusion,” 39 The Tax Adviser 508 (August 2008).

13 Example adapted from Joint Committee on Taxation, Technical Explanation of Division C of H.R. 3221, the “Housing Assistance Tax Act of 2008” 63–64 (JCX-63-08) (July 23, 2008).

14 Sec. 121(d)(6) and Regs. Sec. 1.121-1(d)(1).

15 Sec. 121(b)(4)[5](C)(ii)(I).

16 The sum of 48 months from January 1, 2005, to December 31, 2008, plus 36 months from January 1, 2010, to December 31, 2013.

17 There is no reference to the taxpayer’s former spouse as being a qualifying taxpayer.

18 For example, they are not mentioned in the Joint Committee on Taxation, Description of the Housing Assistance Tax Act of 2008 (JCX-27-08) (April 8, 2008), prepared the day before the bill’s scheduled markup in the House Ways and Means Committee.

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