This tax break is the Section 121 Exclusion, more commonly referred to as the “home sale exclusion.” Learn more about how it works and how you can benefit.
How Does the Home Sale Exclusion Work?
Your capital gain—or loss—is the difference between the sales price and your basis in the property, which is what you paid for it plus certain qualifying costs. You would have a gain of $200,000 if you purchased your home for $150,000 and you were to sell it for $350,000. You wouldn’t have to report any of that money as taxable income on your tax return if you’re single, because $200,000 is less than the $250,000 exclusion. Now let’s say that you sold the property for $450,000. Your gain would be $300,000 in this case: $450,000 less your $150,000 basis. You would have to report a $50,000 capital gain on your tax return for the year because $300,000 is $50,000 more than the $250,000 exclusion.
Calculating Your Cost Basis and Capital Gain
The formula for calculating your gain involves subtracting your cost basis from your sales price. Start with what you paid for the home, then add the costs you incurred in the purchase, such as title fees, escrow fees, and real estate agent commissions. Now add the costs of any major improvements you made, such as replacing the roof or furnace. Unfortunately, painting the family room doesn’t count. The keyword here is “major.” Subtract any accumulated depreciation you might have taken over the years, such as if you ever took a home office deduction. The resulting number is your cost basis. Your capital gain would be the sales price of your home less your cost basis. You’ve suffered a loss if it’s a negative number. Unfortunately, you can’t claim a deduction for a loss from the sale of your main home, or for any other personal property. You’ve made a profit if the resulting number is positive. Subtract the amount of your exclusion, and the balance, if any, is your taxable gain.
The 2-out-of-5-Year Rule
Your property must be your primary residence, not an investment property, to qualify for the home sale exclusion. The home must have been owned and used for a minimum of two out of the last five years immediately preceding the date of sale. The two years don’t have to be consecutive, however, and you don’t have to live there on the date of the sale. This is also referred to as the “residence test.” You can use this 2-out-of-5-year rule to exclude your profits each time you sell your main home, but this means that you can claim the exclusion only once every two years because you must spend at least that much time in a residence. You can’t have excluded the gain on another home in the last two-year period.
Exceptions to the 2-out-of-5-Year Rule
You might be able to exclude at least a portion of your gain if you lived in your home less than 24 months but you qualify for one of a handful of special circumstances such as a change in workplace, a health-related move, or an unforeseeable event. Count the months you were in the residence, then divide the number by 24. Multiply this ratio by $250,000, or by $500,000 if you’re married, and you qualify for the double exclusion. The result is the amount of the gain you can exclude from your taxable income. For example, you might have lived in your home for 12 months, then you had to sell it for a qualifying reason. You’re not married. Twelve months divided by 24 months comes out to .50. Multiply this by your maximum exclusion of $250,000. The result: You can exclude up to $125,000, or 50% of your profit. You would include only the amount of your gain over $125,000 as taxable income on your tax return if your gain was more than $125,000. For example, you would report and pay taxes on $25,000 if you realized a $150,000 gain. You could exclude the entire amount from your taxable income if your gain was equal to or less than $125,000.
Qualifying Lapses in Residency
You don’t have to count temporary absences from your home as not living there. You’re permitted to spend time away on vacation, or for business or educational reasons, assuming you still maintain the property as your residence, and you intend to return there. And you might qualify for a partial exclusion if you’re forced to move due to circumstances beyond your control. For example, you could exclude a part of your gain if your work location changed, so you were forced to move before you’d lived in your house for the qualifying two years. This exception would apply if you started a new job, or if your current employer required you to move to a new location. Document your condition and the situation with a statement from your physician if you’re forced to sell your house for medical or health reasons. This, too, allows you to live in the home for less than two years yet still qualify for the exclusion. You don’t have to file the letter with your tax return, but keep it with your personal records just in case the IRS wants confirmation. You’ll also want to document any unforeseen circumstances that might force you to sell your home before you’ve lived there for the required length of time. According to the IRS, an unforeseen circumstance is “an event that you could not reasonably have anticipated before buying and occupying your main home.” Active duty service members aren’t subject to the residency rule. They can waive the rule for up to 10 years if they’re on qualified official extended duty—the government ordered them to reside in government housing for at least 90 days, or for a period of time without a specific ending date. They’ll also qualify if they’re posted at a duty station that’s 50 miles or more from their home. Members of the Peace Corps are entitled to elect to suspend the running of the five-year period when serving outside the United States.
Other Exclusion Tests and Qualifying Rules
The Ownership Rule
You must also have owned the property for at least two of the last five years. You can own it at a time when you don’t live there, or you can live there for a period of time without actually owning it. For example, if you lived in your apartment for two years before moving out and renting it to a new tenant, then sold it three years later. You will have met both the ownership and the residency two-year rules because you will have lived there for two years and owned it for five. Servicemembers can suspend the usual five-year period for up to 10 years when they’re on qualified official extended duty at a station that’s at least 50 miles from their homes, and they’re living by order in government housing.
The Look-Back Test
The look-back test determines eligibility based on previous home sales. If you sold a home during the last two years but didn’t take an exclusion, or didn’t sell a home within the last two years, you pass the look-back test and can claim the exclusion.
Married Taxpayers
Married taxpayers must file joint returns to claim the exclusion, and must both meet the two-out-of-five-year residency rule. They need not have lived in the residence at the same time, however, and only one spouse must meet the ownership test. A surviving spouse can use their deceased spouse’s residency and ownership time as their own if one spouse dies during the ownership period, and the survivor hasn’t remarried.
Divorced Taxpayers
Your ex-spouse’s ownership of the home and time living there can count as your own if you acquire the property in a divorce. You can add these months to your time of ownership, as well as to your time of residency, in order to meet the ownership and residency rules.
Reporting the Gain
Any profit from the sale of your home is reported on Schedule D (Form 1040) as a capital gain if you realize a profit in excess of the exclusion amounts, or if you don’t qualify for the exclusion. The gain is reported as a short-term capital gain if you owned your home for one year or less. It’s reported as a long-term gain if you owned the property for more than one year. Short-term gains are taxed at the same rate as your regular income, according to your tax bracket. The rates on long-term gains are more favorable: zero, 15%, or 20%, depending on your taxable income. The IRS indicates that most taxpayers pay no more than the 15% rate. Keeping accurate records is key. Make sure your realtor knows that you qualify for the exclusion if you do, and provide proof if necessary. Otherwise, your realtor must issue you a Form 1099-S recording your profit and must send a copy to the IRS as well. This won’t prevent you from claiming the exclusion, but it could complicate things, and you might need the help of a tax professional to straighten it out.
What About Foreclosure or a Short Sale?
It’s unlikely that a gain would result from unfortunate circumstances that result in your lender foreclosing on your mortgage loan or agreeing to a short sale. But either of these events could result in taxable income to you if your lender also were to “forgive” or cancel any remaining balance of your mortgage after the property is sold. Consult with a tax professional.
