Single people can exclude up to $250,000 in earnings from capital gains tax when they sell their primary personal residence, thanks to an Internal Revenue Code (IRC) home sales exclusion. Married taxpayers filing jointly can exclude up to $500,000 in earnings.
This tax exemption is the Section 121 Exclusion, more commonly known as the “home sales exclusion.”
- 1 How does the home sale exclusion work?
- 2 Calculating your cost basis and capital gain
- 3 The 2 out of 5 year rule
- 4 Exceptions to the 2 out of 5 year rule
- 5 Residency Qualifying Lapses
- 6 property rule
- 7 Married Taxpayers
- 8 Divorced Taxpayers
- 9 report profit
- 10 What about foreclosure or a short sale?
- 11 Frequently asked questions (FAQ)
How does the home sale exclusion work?
Your capital gain or loss is the difference between the sales price and your basis in the property, which is what you paid for it plus certain qualified costs. You would make a profit of $200,000 if you bought your house for $150,000 and sold it for $350,000. You wouldn’t have to report any of that money as taxable income on your tax return if you’re single, because $200,000 is less than the $250,000 exclusion.
Now let’s say you sold the property for $450,000. Your profit would be $300,000 in this case: $450,000 minus your basis of $150,000. You would have to report a capital gain of $50,000 on your tax return for the year because $300,000 is $50,000 more than the $250,000 exclusion.
Calculating your cost basis and capital gain
The formula for calculating your profit is to subtract your cost basis from your selling price. Start with what you paid for the house, then add the costs you incurred on the purchase, such as title fees, escrow fees, and real estate agent commissions..
Now add the costs of any major improvements you’ve made, like replacing the roof or furnace. Unfortunately, painting the family room doesn’t count. The key word here is “main”.
Subtract any accumulated depreciation you may have taken over the years, just as if you ever took a home office deduction. The resulting number is your cost basis.
Your capital gain would be the selling price of your home minus your cost basis. You have suffered a loss if it is a negative number. Unfortunately, you cannot claim a deduction for a loss from the sale of your main home or any other personal property. You made a profit if the resulting number is positive. Subtract the amount of your exclusion and the balance, if any, is your taxable profit.
The 2 out of 5 year rule
Your property must be your primary residence, not an investment property, to qualify for the home sale exclusion. You must have lived in the home for a minimum of two of the last five years immediately preceding the date of sale. However, the two years do not have to be consecutive and you do not have to live there on the date of the sale.
You can live in the house for one year, rent it for three years, and then move back in for 12 months. The IRS figures that if you spent that much time under that roof, the house qualifies as your primary residence.
You can use this 2-of-5-year rule to exclude your earnings each time you sell your main home, but this means you can claim the exclusion only once every two years, because you must spend at least that long in residence. You cannot have excluded gain from another home in the last two-year period.
Exceptions to the 2 out of 5 year rule
You may be able to exclude at least part of your earnings if you lived in your home less than 24 months, but you qualify for one of a few special circumstances, such as a change of job location, a health-related move, or an unforeseen event . .
You can calculate and claim a partial home sales exclusion based on the amount of time you actually lived in the residence if you qualify under one of the special rules.
Count the months you were in residence, then divide the number by 24. Multiply this ratio by $250,000, or by $500,000 if you are married and qualify for the double exclusion. The result is the amount of the gain that you can exclude from your taxable income.
For example, you may have lived in your home for 12 months, then had to sell it for a qualifying reason. You are not married. Twelve months divided by 24 months equals 0.50. Multiply this by your maximum exclusion of $250,000. The result: You can exclude up to $125,000 or 50% of your profit.
You would include only the amount of your gain over $125,000 as taxable income on your tax return if your gain was over $125,000. For example, you would report and pay taxes on $25,000 if you made a profit of $150,000. You could exclude the full amount of your taxable income if your gain was $125,000 or less.
Residency Qualifying Lapses
You do not have to count temporary absences from your home as if you did not live there. You are permitted to spend time away on vacation or for educational or business purposes, assuming you still maintain the property as your residence and intend to return there.
And you may qualify for a partial exclusion if you are forced to move due to circumstances beyond your control. For example, you could exclude a portion of your earnings if your place of employment changed and you were forced to move before you lived in your home for the two qualifying years. This exception would apply if you started a new job or your current employer requires you to move to a new location.
Document your condition and situation with a statement from your doctor if you are forced to sell your home for health or medical reasons. This also allows you to live in the home for less than two years and still qualify for the exclusion. You don’t have to file the letter with your tax return, but keep it with your personal records in case the IRS wants confirmation.
You’ll also want to document any unforeseen circumstances that may force you to sell your home before you’ve lived there for the required length of time. According to the IRS, an unforeseen circumstance is “an event that you could not have reasonably foreseen before you purchased and occupied your principal residence.”
Natural disasters, a job change that left you unable to cover basic living expenses, death, divorce, and multiple births from the same pregnancy would all qualify as unforeseen circumstances under IRS rules.
Active duty service members are not subject to the residency rule. They can waive the rule for up to 10 years if they are on official qualified extended service: they were ordered by the government to reside in government housing for at least 90 days, or for a period of time with no specific end date. They will also qualify if they are assigned to a duty station that is 50 miles or more from their home.
You must also have owned the property for at least two of the last five years. You can own it at a time when you don’t live there, or you can live there for a period of time without actually owning it.
Your two years of residence and two years of ownership do not have to be concurrent.
For example, if you lived in your apartment for two years before you moved in and rented it out to a new tenant, then sold it three years later. You will have complied with the two-year ownership and residency rules, because you will have lived there for two years and own it for five.
Service members can also waive this rule for up to 10 years if they are on qualified official extended duty.
Married taxpayers must file joint returns to claim the exclusion and both must meet the two out of five year residency rule. However, they do not need to have lived in the residence at the same time, and only one spouse must meet the ownership test.
The home sales exclusion is not available to married taxpayers who choose to file separate tax returns.
A surviving spouse may use their deceased spouse’s residence and time of ownership as their own if one of the spouses dies during the ownership period and the survivor has not remarried.
Ownership of your ex-spouse’s home and the time you live there can be counted as your own if you acquire the property in a divorce. You can add these months to your ownership time, as well as your residency time, to comply with ownership and residency rules.
Any gain from the sale of your home is reported on Schedule D (Form 1040) as a capital gain if you make a gain in excess of the exclusion amounts, or if you don’t qualify for the exclusion. The gain is reported as a short-term capital gain if you owned your home for one year or less. It is reported as a long-term gain if you owned the property for more than one year.
Short-term earnings are taxed at the same rate as your regular income, based on your tax bracket. Long-term earnings rates are more favorable: zero, 15%, or 20%, depending on your taxable income. The IRS indicates that most taxpayers do not pay more than the 15% rate.
Keeping accurate records is key. Make sure your real estate agent knows that you qualify for exclusion if you do, and provide proof if necessary. Otherwise, your real estate agent must issue you a Form 1099-S that records your gain and must also send a copy to the IRS. This won’t stop you from claiming the exclusion, but it could complicate things and you may need the help of a tax professional to sort it out.
You must report the sale of your home on your tax return if you receive a Form 1099-S. Consult with a tax professional to make sure you don’t take a tax hit you don’t have to take.
What about foreclosure or a short sale?
A gain is unlikely to result from unfortunate circumstances that result in your lender foreclosing on your home loan or agreeing to a short sale. But any of these events could create taxable income for you if your lender also “forgives” or pays off any remaining balance on your mortgage after the property is sold.
Frequently asked questions (FAQ)
Do I have to pay taxes when I sell my house?
You must pay taxes on any part of your home sale that does not qualify for a home sale exclusion. The home must be your primary residence and you must have lived in it and owned it for at least two of the last five years, although your ownership and residence need not be concurrent. You can exclude up to $250,000 in earnings ($500,000 for married couples) for a home that meets these requirements.
How often can you use the home sale exclusion?
Since you must own and live in the home for at least two years and it must be your primary residence, you can use the home sale exclusion no more than once every two years.
How do I claim the home sale exclusion?
When you sell your home, you’ll receive Form 1099-S, which contains the information you need to include on your annual tax return. You will use IRS Schedule D and Form 8949 to report the proceeds from your sale and claim any exclusions for which you are eligible.