Understanding the Home Sale Exclusion
Will You Qualify for the Home Sale Gain Exclusion?
Selling your primary residence? Learn how the powerful home sale exclusion can significantly reduce your tax bill. This guide explains the eligibility requirements, including ownership and use periods, and discusses special situations like divorce, military service, and converting rental properties. We’ll also cover how to track home improvements to maximize your exclusion and discuss the “stepped-up” basis rules for surviving spouses. Discover how to minimize your tax burden and keep more of your hard-earned equity when selling your home.
Exclusion Basics
Normally, when you sell appreciated real estate or other capital assets you’ve held for more than one year, your gains are subject to capital gains taxes at a rate of 15% or 20% (depending on your tax bracket). If your income is high enough, you may also be subject to an additional 3.8% net investment income tax. So, a high-income taxpayer who sells real estate for a $250,000 profit would potentially be liable for $59,500 in taxes ($250,000 x 23.8%).
Fortunately, the tax code offers a generous tax exclusion for gain from the sale of your principal residence. The exclusion allows single filers to avoid taxes on up to $250,000 in gain. For married couples filing jointly, the exclusion is doubled, to $500,000.
Meeting the Requirements
If you’re planning to sell your principal residence, don’t assume that you automatically qualify for the exclusion — check to be sure you meet the eligibility requirements. If you’re single, you must have owned the home and used it as your principal residence for at least 24 months of the five-year period preceding the sale.
If you’re a married couple filing jointly, then at least one of you must have owned the home for at least 24 months of the preceding five years and both of you must have used it as your principal residence for at least 24 months of the preceding five years. Technically, two different homes could meet these requirements at the same time, but you’re not permitted to claim the exclusion more than once in a two-year period.
Other Situations
The eligibility rules get more complicated for couples who are separated or divorced, homeowners who move to nursing homes, and military personnel. Also, if work or health circumstances require you to move before you meet the 24-month threshold, you may qualify for a partial exclusion. Be sure to consult your tax advisor if any of these situations apply to you.
Special rules apply to the conversion of an ineligible residence into a principal residence. Suppose you and your spouse have owned a home for 10 years and have used it as a rental property for six years and as your principal residence for the past four years. If you sell the home for a $500,000 profit, only 40% of that amount (4/10) is eligible for the exclusion. That means $200,000 in gain is excluded and the remaining $300,000 is taxable.
“The home sale exclusion can significantly reduce your tax bill. Understanding the eligibility requirements and tracking home improvements are crucial for maximizing this valuable tax benefit.”
Track Improvements
It’s important to keep track of home improvements. Your gain on the sale of a home is generally equal to the selling price minus your cost basis, which is the purchase price plus or minus certain adjustments. Some home improvements (for example, an addition or a kitchen remodel) may increase your basis, thereby reducing your gain. So, it’s critical to document these expenses.
In addition, if your spouse dies, you can still claim the full $500,000 exclusion if you sell your principal residence within two years and haven’t remarried. Be aware, however, that if you and your spouse owned the home jointly, you’ll be entitled to significant tax benefits regardless of when you sell. That’s because your spouse’s share of the home’s value receives a “stepped-up” cost basis. In some community property states, the full value of the home gets a step-up.
Preparing for a Sale
Before you sell your principal residence, be sure you understand the tax implications. Calculate your expected gain (selling price minus adjusted cost basis) and determine the amount of your home sale gain exclusion.
Understanding the Home Sale Exclusion: Will You Qualify?
By carefully understanding the rules and documenting your expenses, you can potentially significantly reduce your tax liability when selling your primary residence. Consulting with a qualified tax advisor is highly recommended to ensure you maximize your exclusion and navigate any complex situations that may apply to your specific circumstances.
Disclaimer: This article provides general information and should not be considered professional tax advice. The information presented here may not apply to all situations, and tax laws are subject to change.
Questions?
Ryan specializes in federal, state, and local tax compliance services for individuals, single-member LLCs, partnerships, and corporations. He serves a diverse clientele across various industries, ranging from small businesses to large corporations. Additionally, Ryan has experience in supporting individuals and businesses with SBA loan applications.