Summary of Changes to Section 121 in the Housing and Economic Recovery Act of 2008

The Housing and Economic Recovery Act of 2008 (HERA) brought several changes to the U.S. tax code in response to the housing crisis. One of the most significant adjustments for real estate investors and homeowners was to Section 121 of the Internal Revenue Code, which provides the primary residence exclusion.

Under Section 121, taxpayers may exclude up to $250,000 of capital gain ($500,000 for married couples filing jointly) from the sale of their primary residence, provided they meet ownership and use requirements. HERA modified how this exclusion applies when a property has been used partly as a primary residence and partly for other purposes, such as rental or investment.

The Key Change: Allocation of Gain

Before 2008, many taxpayers converted rental or vacation properties into their primary residences for a short period, then sold the property and claimed the full Section 121 exclusion. This strategy allowed significant investment property gains to be excluded from tax.

HERA closed this loophole by introducing a pro-rata allocation rule:

• “Nonqualified use” periods (when the property was not used as the taxpayer’s primary residence) reduce the portion of gain eligible for exclusion.

• Only gain attributable to periods of qualified use (when the property was the taxpayer’s principal residence) may be excluded under Section 121.

Definition of Nonqualified Use

Nonqualified use generally includes:

• Any period after January 1, 2009, when the property is not used as a primary residence (e.g., rental, investment, vacation home).

Exceptions:

• Periods before 2009 are not counted as nonqualified use.

• Temporary absences (up to 2 years) due to employment, health, or military service are not considered nonqualified use.

• Periods after the last qualified use (e.g., renting the property after moving out while waiting to sell) do not reduce the exclusion.

Example

Suppose an investor owns a property for 10 years:

• Rents it out for 4 years (2009–2012).

• Lives in it as a primary residence for 6 years (2013–2018).

• Sells in 2019 with $300,000 of gain.

Result:

• 4/10 of the gain ($120,000) is allocated to nonqualified use and not excludable.

• The remaining $180,000 may be excluded under Section 121, subject to the $250,000/$500,000 limits.

Why This Matters

The change prevents taxpayers from converting investment properties to short-term residences solely to shelter gain from taxes. It ensures that the Section 121 exclusion is primarily reserved for genuine personal residences, while still offering flexibility for those who legitimately move into former rentals or investment properties.

✅ The Housing and Economic Recovery Act of 2008 made Section 121 more restrictive but preserved its benefits for true homeowners. For those holding mixed-use properties, it’s essential to understand these allocation rules before selling.