You probably know that, if you sell your home, you may exclude up to $250,000 of your capital gain from tax. For married couples filing jointly, the exclusion is $500,000. Also, unmarried people who jointly own a home and separately meet the tests described below can each exclude up to $250,000.
The law applies to sales after May 6, 1997. To claim the whole exclusion, you must have owned and lived in your home as your principal residence an aggregate of at least two of the five years before the sale (this is called the ownership and use test). You can claim the exclusion once every two years.
But, even if you don't meet this test, you still may be entitled to a whole or partial tax break in certain circumstances.
First, How Much Is Your Gain?
Many people mistakenly believe that their gain is simply the profit on the sale ("We bought it for $100,000 and sold it for $650,000, so that's a $550,000 gain, and we're $50,000 over the exclusion, right?"). It's not so simple -- a good thing, since the fine print can work to your benefit in such instances.
Your gain is actually your home's selling price, minus deductible closing costs, selling costs, and your tax basis in the property. (Your basis is the original purchase price, plus purchase expenses, plus the cost of capital improvements, minus any depreciation and minus any casualty losses or insurance payments.)
Deductible closing costs include points or prepaid interest on your mortgage and your share of the prorated property taxes.
Examples of selling costs include real estate broker's commissions, title insurance, legal fees, advertising costs, administrative costs, escrow fees, and inspection fees.
So, for example, if you and your spouse bought a house for $100,000 and sold for $650,000, but you'd added $20,000 in home improvements, spent $5,000 fixing the place up for the sale, and paid the real estate brokers at least $25,000, the exclusion plus those costs would mean you'd owe no capital gains tax at all.
For more information, see IRS Publication 551, Basis of Assets, and look for the section on real property.
If You Don't Meet the Use Test
Now let's say that you still have some capital gains that don't seem to fall under the exclusion. Even if you haven't lived in your home a total of two years out of the last five, you're still eligible for a partial exclusion of capital gains if you sold because of a change in your employment, or because your doctor recommended the move for your health, of if you're selling it during a divorce or due to other unforeseen circumstances such as a death in the family or multiple births. ("I changed my mind about living here" won't cut it.) In such a case, you'd get a portion of the exclusion, based on the portion of the two-year period you lived there. To calculate it, take the number of months you lived there before the sale and divide it by 24.
For example, if an unmarried taxpayer lives in her home for 12 months, and then sells it for a $100,000 profit due to an unforeseen circumstance, the entire amount could be excluded. Because she lived in the house for half of the two-year period, she could claim half of the exclusion, or $125,000. (12/24 x $250,000 = $125,000.) That covers her entire $100,000 gain.
Nursing Home Stays
For people who've moved to a nursing home, the ownership and use test is lowered to one out of five years in your own home before entering the facility. And time spent in the nursing home still counts toward ownership time and use of the residence. For example, if you lived in a house for a year, and then spent the next five in a nursing home before selling the home, the full $250,000 exclusion would be available.
Marriage and Divorce
Married couples filing jointly may exclude up to $500,000 in gain, provided:
- either spouse owned the residence
- both spouses meet the use test, and
- neither spouse has sold a residence within the last two years.
Separate residences. If each member of a married couple owns and occupies a separate residence and files jointly, each may exclude up to $250,000 in gain when they sell. Also, if it's a new marriage and one spouse sold a residence within two years before the marriage (thereby disqualifying him- or herself from the exclusion), the other spouse may still exclude up to $250,000 in gain on a residence owned before the marriage.
Double tax breaks? A new marriage may also double the tax break in some circumstances. Suppose a single man sold his principal residence on October 1 and gained $500,000 in profits. Let's also say that he and his girlfriend had been living in the house for two years (but her name wasn't on the title), so they both satisfy the use test. If they get married by midnight December 31 of the same year, they can file a joint return for that year and exclude the entire $500,000.
Divorce and the tax break. Divorced taxpayers may tack on the ownership and use of their residence by their former spouse. For example, say that upon divorce, the wife is allowed to live in the husband's residence until she sells it. He has owned the residence for 18 months. Once the sale occurs, the couple will split the profits 50-50.
If the wife sells the home nine months later, she may tack on her ex-husband's ownership to meet the two-year ownership test. Also, the husband may tack on his ex-wife's continued use of the residence to meet the two-year use test. Each one is entitled to exclude $250,000 of profits from the sale. Widowed taxpayers may also tack on the ownership and use by their deceased spouse.
Reduced Exclusion for Second Home Also Used as Primary Home
As of January 2009, new tax rules require that, if you sell a home that you sometimes used as a vacation or rental property and sometimes as your primary residence, you're eligible for only that portion of the capital gains exclusion that corresponds to the amount of time you actually lived there as your primary residence. (The rest of the time is called "non-qualifying use.") Note that the calculation is made over more than a mere five-year period -- it applies right back to January of 2009. What's more, if, during the five years before the sale, you never actually made the home your primary residence, you're likely disqualified from using the exclusion. (You won't be surprised to hear that this new rule was meant to generate additional tax revenue, to offset some other tax cuts.)
Home Offices: A Tax Drawback
The exclusion does not apply to depreciation allowable on residences after May 6, 1997. If you are in a high tax bracket and plan to live in your home for a long time, taking depreciation deductions for a home office is quite valuable right now. But if not, you might want to reconsider using a portion of your home as an office, because all depreciation deductions you take will be taxed at 25% when you sell the house.
Example: A married couple sells a home with an adjusted basis (purchase price plus capital improvements) of $100,000 for $600,000. Over the years, they had taken $50,000 in depreciation deductions for a home office.
Sales Price: $600,000
Adjusted Basis - $100,000
Taxable gain = $500,000
Of that gain, $450,000 is tax-free; the $50,000 taken as depreciation deductions is subject to 25% capital gains tax.
Splitting Up Big Gains
If you expect huge gains from selling a house -- more than can be excluded from tax -- you should consider ways to divide ownership of the house.
For example, say a couple owns their residence together with their adult son (perhaps because they've given him a share). If he meets the ownership and use tests as to one-third of the property, the son may sell his share for a $250,000 gain without incurring a tax. His parents could simultaneously sell their share for $500,000 without tax, sheltering the entire $750,000 gain.