The Home Sale Tax Exemption
Before the 1997 Taxpayer Relief Act, you could find yourself facing significant capital gains taxes on the sale of your house unless you upgraded to a more expensive house. With the passage of the Act, however, individuals can exclude up to $250,000 of capital gains from taxation, while married couples can exclude up to $500,000.
The "Use" Test and the Home Sale Tax Exemption
- Exemption Limited to Every Two Years: You can only qualify for the home sale exemption from the capital gains tax once every two years.
- The Use Test: To qualify for the home sale capital gains tax exemption, you must have owned and lived in the residence for a total of two out of the last five years before the sale. That time does not have to be continuous, which would allow you to live in the house for the first year, rent it for three years, then live in it for the fifth year and still qualify.
- If You Fail the Use Test: Even if you fail the use test, you can still get a prorated exclusion on your capital gains if you sold your house because of a change in employment, health reasons, or other unforeseen circumstances. For example, if you only lived in a house for a year because of a job change, you would be entitled to a $125,000 exemption (half of the $250,000 exemption you would have received).
- Nursing Home Exception: While normally you are required to own and live in the house for two of the last five years, people who end up living in a nursing home can have this requirement lessened to only one out of five years. In addition, time spent in the nursing home counts towards the use test as if it were the original home.
- Home Office Exception: Be aware that if you are taking depreciation deductions for a home office, that amount will be subtracted from your capital gains exclusion. For example, if you were normally entitled to $250,000, but had taken $50,000 in depreciation deductions for a home office, you would only be entitled to a $200,000 exclusion from your capital gains.
Types of Homeowners and the Home Sale Tax Exemption
- Individual Owners: If each individual passes the use test, then each individual is entitled to a $250,000 exemption from capital gains taxes. This would mean that if you co-owned a house with another individual, but were unmarried, each individual could exclude $250,000 of capital gains from taxation.
- Married Couples: Married couples who file jointly are entitled to a $500,000 exclusion from capital gains so long as either spouse owned the residence and both spouses meet the use test.
- Newly Married Couples Bonus: If an unmarried couple bought a house and lived in it for one and a half years, and then got married, they can use that year and a half towards the two year requirement. This means they only need to live in the house as a married couple for six more months to qualify.
- Divorced Couples: Divorced couples can add the ownership and use of their former spouse to meet the use test. For example, if a couple had been living in a house for a year and a half and got divorced and the wife got the house, she would only need to live in the house for an additional six months to qualify.
If A Sale Will Exceed the Home Sale Tax Exemption
If the sale of your house will exceed the capital gains exclusion you can receive, consider alternative ways of structuring use and ownership of your house to maximize the possible exclusions. For example, assume you are a married couple, who has an adult daughter living with you and the sale of your house will generate $750,000 in profit. In this case, you might consider giving that daughter one-third ownership of the house. That way you can apply your $500,000 towards the $500,000 you and your spouse would receive as profit, and if your daughter has owned and lived in the house for two years, she would qualify for a $250,000 exclusion as an individual. This would allow you, as a family, to get a total of $750,000 in profits and have all of it excluded from capital gains taxation.