Many of my clients are first time home buyers and many are people who have bought before and now looking to upgrade or have to relocate due to unforeseen circumstances.
It always starts with good intentions. You list your house for sale and hope for the best. Then fortune smiles on you, you sell it for a tidy profit, and you realize that you might have to give a healthy percentage of that profit to the Internal Revenue Service in the form of capital gains tax.
It's not necessarily so. Many taxpayers can keep most—if not all—of that money. You can exclude it from your taxable income using the home sale exclusion provided by the Internal Revenue Code.
$250,000 Exclusion on the Sale of the Main Home
Unmarried individuals can exclude up to $250,000 in profit from the sale of their main home. You can exclude $500,000 if you're married.
Here's how it works: If you're single and you realize a $200,000 profit on the sale of your home, you don't have to report any of that money as taxable income. It's less than the $250,000 exclusion amount you're entitled to. If you realize a $255,000 profit or gain, you must report $5,000 of it as a capital gain.
Of course, quite a few rules apply.
The 2-Out-Of-5-Year Rule
The exclusion depends on the property being your residence, not an investment property. You must have lived in the home for a minimum of two out of the last five years immediately preceding the date of the sale.
The two years don't have to be consecutive and you don't actually have to live there on the date of the sale. You can live in the home for a year, rent it out for three years, then move back in for 12 months. The IRS figures that if you spent this much time under that roof, the home qualifies as your principal residence.
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 residence. You cannot have excluded the gain on another home in the last two-year period.
Exceptions to the 2-Out-of-5 Year Rule
If you lived in your home less than 24 months, you might be able to exclude at least a portion of the gain if you qualify for one of a handful of special circumstances. You can then calculate your partial exclusion based on the amount of time you actually lived there.
Count the months you were in residence then divide the number by 24. Multiply this ratio by $250,000 or by $500,000 if you're married. 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 percent of your profit.
If your gain is more than $125,000, you would include only the amount over $125,000 as taxable income on your tax return. If you realize a $150,000 gain, you would report and pay taxes on $25,000. If your gain is equal to or less than $125,000, you can exclude the entire amount from your taxable income.
Qualifying Lapses in Residency
You don't have to count reasonably temporary absences from the home as not living there. You're permitted to spend time away on vacation or for business reasons assuming you still maintain the property as your residence and you intend to return there.
And if you actually have to move, you might qualify for the partial exclusion. If you lived in your house for less than two years, you can exclude a part of your gain if your work location changed. This exception would apply if you started a new job or if your current employer required you to move to a new location.
If you're selling your house for medical or health reasons, document these reasons with a letter from your physician. This, too, allows you to live in the home for less than two years. 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 the required period of time. According to the IRS, an unforeseen circumstance is "the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home," such as natural disasters, a change in your employment or unemployment that left you unable to meet basic living expenses, death, divorce, or multiple births from the same pregnancy.
Active-duty service members are not subject to the residency rule. They can waive the rule for up to 10 years if they're on "qualified official extended duty." This means the government ordered you to reside in government housing for at least 90 days or for a period of time without a specific ending date. You'll also qualify if you're posted at a duty station that's 50 miles or more from your home.
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 live there for a period of time without actually owning it. The two years of residency and the two years of ownership don't have to be concurrent.
You might have rented your home and lived there for three years, then you purchased it from your landlord. You promptly moved out and rented it to another individual, then you sold it two years later. You've met both the ownership and the residency two-year rules—you lived there for three and owned it for two.
Service members can waive this rule as well for up to 10 years if they're on qualified official extended duty.
Married taxpayers must file joint returns to claim the exclusion, and both must meet the 2-out-of-5 year residency rule although they don't have to have lived in the residence at the same time. Only one spouse must meet the ownership test.
If one spouse dies during the ownership period and the survivor hasn't remarried, she can use her deceased spouse's residency and ownership time as her own.
Your ex-spouse's ownership of the home and time living in the home can count as your own if you acquire the property in a divorce. You can add these months to your time of ownership and living there to meet the ownership and residency rules.
Reporting the Gain
If you realize a profit in excess of the exclusion amounts or don't qualify, the income on the sale of your home is reported on Schedule D as a capital gain. If you owned your home for one year or less, the gain is reported as a short-term capital gain. If you owned it more than one year, it's reported as a long-term capital gain.
Short-term gains are taxed at the same rate as your regular income while the rates on long-term gains are more favorable: zero, 15 or 20 percent, depending on your tax bracket.
Keeping accurate records is key. Make sure your realtor knows you qualify for the exclusion if you do, offering proof if necessary. Otherwise, she must issue you a Form 1099-S and send a copy to the IRS. This doesn't preclude you from claiming the exclusion but it can complicate things.
If you receive Form 1099-S, you must report the sale of your home on your tax return. Consult with a tax professional to make sure you don't take a tax hit if you don't have to.
Calculating Your Cost Basis and Capital Gain
The formula for calculating your gain involves subtracting your cost basis from your selling price.
Start with what you paid for the home, then add the costs you incurred in the purchase such as title and escrow fees and real estate agent commissions. Now add the costs of any major improvements you made, such as replacing the roof or furnace. Sorry, painting the family room doesn't count.
Subtract any accumulated depreciation you might have taken over the years, such as if you ever took the 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. If it's a negative number, you've had a loss. Unfortunately, you cannot deduct a loss from the sale of your main home.
If the resulting number is positive, you made a profit. Subtract the amount of your exclusion and the balance is your taxable gain.