Ins and Outs of the Home Sale Exclusion

If you bought your home years ago, you might be sitting on a huge tax gain when you finally sell the place. Fortunately, a special tax law provision may enable you to reduce or completely avoid the resulting capital gains tax. This provision includes both a “use” and “ownership” test.

Background: By making a tax return election, you can exclude from taxable income up to $250,000 of gain—or $500,000 for joint filers— from the sale of a home. To qualify for this tax exclusion, you must have owned and used the home as your principal residence for at least two of the five years prior to the sale.

This home sale generally does not apply, however, if you’ve sold another qualified principal residence within the last two years. Theoretically, someone could qualify for the home sale exclusion every two years.

Keeping those basic rules in mind, here are several key points about the home sale exclusion that you should know about before you hand over the keys.

The home may be used as a principal residence for any two of the last five years. The years do not have to be consecutive. Furthermore, you can meet the use and ownership requirements in different tax years.

Joint filers can claim the maximum exclusion if (1) either spouse meets the two-year ownership test, (2) each spouse meets the two-year use test and (3) neither spouse has elected the exclusion within the last two years. This is particularly important for folks who have recently divorced or remarried.

In order to meet the use requirement, you must physically occupy the home, but short absences are allowed. Conversely, a longer absence, such as a one-year sabbatical by a college professor, does not count as time that the home is being used as the principal residence.

If someone owns two homes and lives in both places during the year, the home where that person stays for most of the year is generally treated as the principal residence. For instance, if you spend seven months of the year at a “winter home” located in a warm climate and five months at your other home, the winter home is considered to be the principal residence.

To the extent that the home has been used for business or rental use— including using a portion of the residence as a home office—you must recapture depreciation deductions attributable to the period after May 6, 1997. The recaptured income is taxed at the 25% rate as opposed to the current maximum 20% capital gains rate (15% for certain taxpayers).

Finally, a partial exclusion may be available due to a change in employment, a health reason or other unforeseen circumstances from an event that could not have reasonably anticipated.

Reminder: This is only a general overview of some of the ins and outs of the home sale exclusion. It is recommended that homeowners obtain professional assistance concerning the tax ramifications of the sale of their principal residence.