If you know when and how to sell your home, if you know the game, you won’t have to pay any tax on up to $250,000 of the gain from the sale of your principal home if you’re single, or up to $500,000 if you’re married and file a joint return. You’re not suggested to sell your home just to get a tax break. But if you do plan to sell, you may qualify for the largest tax break you’ll ever. This isn’t tax evasion, which means cheating—for example, not reporting all your income to the IRS. Tax evasion is illegal, and people who are caught at it must pay all the taxes they owe, plus interest and penalties. Some even go to jail.
How often do Americans sell their homes? The average is every seven years, and tree out of ten taxpayers mistakenly believe that they can write of losses from a home sale, according to a survey by cch.com. Even if you think you know all about this exclusion, keep reading to make sure you truly qualify and can make the most of it.
You may do anything you want with the tax-free proceeds from the sale. If you buy another home, you can qualify for the exclusion in another two years if and when you sell that house. Indeed, you can use the exclusion any number of times over your lifetime as long as you satisfy the requirements discussed in this post.
Of course, the exclusion won’t do you much good if you sell during a market that’s gone fat, so that you don’t earn any profit from your sale. And you can’t write of losses on a home sale. But no matter what your local market is doing right now, U.S. real estate values have historically moved steadily upward. a time will probably come when you’ll be able to take advantage of the exclusion.
Goodbye the Old “Home-Sale-Exclusion” Law
The $250,000/$500,000 home sale exclusion came into effect in 1997. Before then, there were two different tax breaks for homeowners who sold their principal homes. One allowed homeowners to avoid (defer) any tax on their profits from a home sale if they purchased a new home within two years that cost as much as or more than their old home. Another law allowed taxpayers who were at least 55 years old to exclude onetime, and one time only, up to $125,000 in profit when they sold their home.
You can forget about these old laws. They are no longer in effect. If you meet the requirements discussed below, you may take advantage of the $250,000/$500,000 exclusion even if you previously used one or more of the old laws to avoid taxes on a home sale.
How Can I Show Two Years Ownership and Use?
Here’s the most important thing you need to know:
to qualify for the $250,000/$500,000 home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it. Your two years of ownership and use can occur anytime during the five years before you sell—and you don’t have to be living in the home when you sell it.
One aspect of the exclusion that can be confusing is that ownership and use of the home don’t need to overlap. As long as you have at least two years of ownership and two years of use during the five years before you sell the home, the ownership and use can occur at different times. This rule is most important for renters who end up purchasing their rental apartments or rental homes. The time that they lived in the home as a renter counts as “use” even though if they didn’t own the place at the time.
How Do I Know If My Home Qualifies As My Principal Residence?
It needs to have been the place where you (and your spouse, if you’re claiming the $500,000 exclusion) live. You can have only one principal residence at a time. If you live in more than one place—for example, the property you use the majority of the time during the year will be your principal residence for that year. It doesn’t matter whether your home is a house, apartment, condominium, townhouse, stock cooperative (a co-op apartment, for example), a mobile home a fixed to land, or even a houseboat— they all can qualify for the exclusion.
Starting in 2009, a new law will limit the $250,000/$500,000 exclusion for homeowners who initially use their home for purposes other than their principal residence. For example: someone might originally own property as a rental or vacation home and then later convert it to a principal residence. In those circumstances, you must reduce pro rata the amount of profit you exclude from your income based on the number of years after 2008 you used the home as a rental, vacation home, or other “non-qualifying use”.
A non-qualified use can occur only before the home was used as the taxpayer’s principal residence. Time periods after the home was used as the principal residence do not constitute a non-qualified use. This is why Jane’s non-qualifying use during 2013 does not reduce her exclusion. Similarly, converting your primary home into a vacation home won’t reduce your exclusion when you sell as long as the house was your principal residence for two of the fve years before the sale.
The most likely way for you to miss out on the benefits of this exclusion is to forget about the two-year requirement, and sell too early.
The two-year rule is really quite generous, since most people live in their home at least that long before they sell it. By wisely using the exclusion, you can buy and sell many homes over the years and avoid any income taxes on your profits.
How If I Need To Sell My Home Early? Use Partial Exclusions
What if you have no choice but to sell your home at a time when you don’t comply with all the requirements for the exclusion? Say, for example, you must sell before you’ve lived in the home for two years, or you’ve already used the exclusion for another home less than two years ago. You may still qualify for a partial exclusion if you have a good excuse for selling the property. Good excuses include:
- A Change in Your Place of Employment. A change in the place of employment is always a valid excuse if the location of the new job is at least 50 miles away from your old home. moves of fewer than 50 miles may qualify depending on the circumstances.
- Health Problems That Require You to Move. Health problems are a valid excuse if a doctor recommends that you move—for example, you have asthma and your doctor tells you that living in Arizona would be better for you than Maine. The health problems can be yours, any co-owner of the property’s, or a close family member’s—for example, a spouse, child, or parent. Thus, for example, you can move if you need to be closer to an ill parent. If you want to use the health exception, be sure to get a letter from your doctor stating that the move is for health reasons and what they are. Keep the letter with your tax files; or
- Circumstances you didn’t foresee when you bought the home that force you to sell it—for example: a death in the family, losing your job and qualifying for unemployment, not being able to afford the house anymore because of a change in employment or marital status, a natural disaster that destroys your house, or you or your spouse have twins or other multiple births.
The amount of the exclusion will usually be based on the percentage of the two years that you met the requirements. For example: if you own and occupy a home for one year (50% of two years), you may exclude 50% of the regular maximum amount—up to $125,000 for a single taxpayer and $250,000 for married couples. you can fgure the percentage using days or months.
What if I Want to Use $500,000 Exclusion for Married Couples?
If you’re married and want to use the full $500,000 exclusion, you’ll need to show that all of the following are true:
- You are legally married and file a joint return for the year;
- either you or your spouse meets the ownership test;
- both you and your spouse meet the use test; and
- during the two-year period ending on the date of the sale, neither you nor your spouse excluded gain from the sale of another home.
If either spouse does not satisfy all these requirements, the exclusion is figured separately for each spouse—meaning each can qualify for up to $250,000. when figuring out ownership and use, each spouse is treated as having owned the property during the period that either spouse owned the property.
Starting in 2008, if your spouse dies and you sell your home, you qualify for the $500,000 exclusion if the sale occurs within two years after the date of death and all the other requirements were met immediately before the date of death [That’s a switch from a more stringent prior law, which, among other things, gave the surviving spouse less time to sell the house].
Can Unmarried Couples Use The Exclusion? How?
For joint owners who are not married, up to $250,000 of gain is tax free for each qualifying owner.
Can Divorcing Couples Use The Exclusion? How?
If you’re divorcing and you own a house together that has gone up in value since you bought it, there are ways to get the full $500,000 exclusion, but you’ll need to make sure you both own the house when you sell.
If you’re not yet divorced, avoid giving the house to one person in the course of the divorce. If that person later sells, they’ll receive all the profit (as sole owner) and will have no way of bringing the ex-spouse into the picture to expand the exclusion beyond $250,000. If you can’t afford to hang onto the house while going your separate ways, it would be better to sell the house while you’re still married.
How If My Gain On The Sale Exceeds The Exclusion?
If you qualify for the $250,000 or $500,000 exclusion and your profit from the sale of your home is less than that amount, you’re sitting pretty. You’ll owe no income tax on the sale. Indeed, you don’t even have to report the sale on your income tax return. On the other hand, if your profit exceeds your exclusion amount, you’ll have to list the excess as taxable income and pay tax on it.
Remember—it’s not the total amount of money you receive for the sale of your home, but the amount of gain on the sale that determines your tax bill. If you owned the home for at least 12 months, you’ll be taxed at the long-term capital gains rate, currently 15% for most people.
Limits on The Exclusion If You’ve Claimed A Home Office
Even if you qualify for the home sale exclusion, you’ll owe some tax if you had an office in your home and took the home office deduction in prior years. That’s because you were getting a depreciation deduction for the home office portion of your property—something you don’t get for property used for personal purposes. You’ll have to pay a 25% income tax on all the depreciation deductions you took after may 6, 1997 on the office.
Things don’t work out nearly as well if you use a separate building, such as a free-standing garage, as an office (instead of using a space inside your home). The separate building is treated as a commercial property separate from your home. You’ll need to allocate the gain on the sale of your property between the two properties, and the exclusion can be used only for the gain on the sale of your actual home.
What to Do If I Don’t Qualify For the Home Sale Exclusion
If you don’t qualify for the home sale exclusion at all, you’ll have to pay tax on all the gain from the sale of your home. If you owned the home for at least one year, you’ll at least qualify for the long-term capital gains rate, which is currently 15% for most taxpayers. If you owned the property for less than one year, you’ll have to pay tax at the short-term capital gains rate, which is the same rate as for ordinary income—up to 35%, depending on your tax bracket.
If selling means a huge tax bill, you may want to think about possible alternatives.
- You could convert the home into a rental property and either hold onto it or exchange it for another rental property; or
- You could sell the home in an installment sale, meaning the buyer pays you the purchase price over several years instead of all at once. You still have to pay tax on any profit you obtain over your applicable exclusion, but you pay only a little at a time as you receive your installment payments.
The Tax Advantages To Staying In One House
The single most effective way to avoid capital gains taxes on your home is, of course, to make it your permanent home. And there’s another tax benefit to staying put: When you die, your home’s value for tax purposes is “stepped up” to its fair market value. As a result, no tax would ever be paid, by you or your heirs, on the appreciation your home earned while you were alive.
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