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. Capital gains taxes are taxes on any profit you make from the sale of something, such as a house. These taxes apply unless you upgraded to a home with a more expensive purchase price.
With the passage of the Act, however, individuals can exclude up to $250,000 of capital gains from taxation. Married couples can exclude up to $500,000. Tax rates are usually up to 15%, so an example of this is:
- Selling a house for $550,000
- You originally purchased the home for $250,000
- You made a profit of $300,000
- If you are unmarried, you can exclude $250,000 in taxes. You will only pay 15% taxes on the remaining $50,000, so about $7,500.
- If you are married, you can exclude $500,000, so the entire profit is tax-free.
Calculating Your Profit on a House
First, look at the original purchase price of your primary residence. These extra fees are not tax deductions, but they do count towards the total cost of the house:
- Closing costs
- Attorney fees
- Real estate agent fees
Now, look at the selling price. The difference in money is what may be tax-free according to the type of owner you are. Home improvements usually help the house sell for a better price, so those sometimes help you make a profit.
Requirements for Married Capital Gains Exclusions
You must be legally married and complete married filings for your taxes. The $500,000 tax break will not be "taxable income" as long as you file a joint return in the same year you purchase your new home.
The "Use" Test and the Home Sale Tax Exemption
Tax exemption rules have some strict exceptions that you need to understand. Not following these rules can get you in trouble during the sale of your home or with the IRS. Trying to work around these laws is tax fraud.
Exemption Limited to Every Two Years
You can only qualify for the home sale exemption from the capital gains tax once every two years. This is sometimes called the "two-year rule."
The Use Test
To qualify for the home sale capital gains tax exemption, you must pass the use test (looking at whether you "used"/lived in your home). You must have owned and lived in the residence for at least two out of the last five years before the sale. That time does not have to be continuous. An example could be:
- You lived in the house for the first year
- You rented the house as a rental property for three years
- You lived in the house for the fifth year
In this example, you have lived in the house for two of the five years, so you still qualify for the tax exemption.
If You Fail the Use Test
Even if you fail the use test above, you can still get a prorated exclusion on your capital gains. This applies 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 unmarried exemption you would have received).
Nursing Home Exception
You usually are required to own and live in the house for two of the last five years. However, people who end up living in a nursing home can have this requirement lessened to only one out of five years.
Also, time spent in the nursing home counts towards the use test as if it were the original home.
Home Office Exception
If you are taking depreciation deductions for a home office, that amount will be subtracted from your capital gains exclusion. For example:
- You were normally entitled to $250,000
- You took $50,000 in tax 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
The kind of owner you are and your tax filing status can change your exemptions. This is sometimes called the "ownership test."
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 who file jointly are entitled to a $500,000 exclusion from capital gain tax. Tax laws say either spouse can own the residence. However, both spouses must 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 period requirement. This means they only need to live in the house as a married couple for six more months to qualify for the $500,000 tax exclusion.
Divorced couples can add the ownership and use of their former spouse to meet the use test. For example:
- A couple lives in a house as their main home for a year and a half
- They get divorced, and the wife gets the house
- The wife 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
The sale of your house could exceed the capital gains exclusion you can receive. If this is the case, consider alternative ways of structuring the use and ownership of your home to maximize the possible exclusions.
- Assume you are a married couple who has an adult daughter living with you
- The sale of your house will generate $750,000 in profit
- You can consider giving that daughter one-third ownership of the house
- Now you can apply your $500,000 towards the $500,000 you and your spouse would receive as profit. If your daughter has owned and lived in the house for two years, she would also 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.
Questions About the Home Sale Tax Exemption? Ask an Attorney
If you're thinking of selling your home and are concerned about capital gains taxes, there are several things you can do.
While researching on your own might sound like the cheapest way to proceed, you shouldn't gamble on your finances, particularly when Uncle Sam is involved. Contact a local real estate attorney to learn more about the home sale tax exemption and whether or not it applies to your unique situation.