Do you know the ins and outs of taxation on home sales? If your answer is “no,” you certainly aren’t alone. Many people still remember pre-1997 rules that placed difficult restrictions on taxpayers before they could earn capital gains benefits.
Today, tax treatment of a primary residence offers the potential to earn substantial benefits. The rules under Internal Revenue Code Section 121 now allow for an exclusion from income taxes on up to $500,000 in gain on the sale of a personal residence if married, filing jointly. Single filers may exclude up to $250,000. And military members enjoy significant additional benefits under certain circumstances.
To qualify for the exclusion, taxpayers must meet several requirements:
Ownership: The taxpayer must own the home for two out of the previous five years. For a married couple, only one person needs to meet the ownership test.
Use: The taxpayer must use the home as his or her principal residence for two out of the previous five years. For a married couple, both persons must meet the use requirements. If one spouse does not meet the two-year use requirement, the exclusion is only $250,000.
Frequency: This exclusion is allowed every two years. If one spouse has sold a principal residence within the past two years, the exclusion again is limited to $250,000.
These popular rules turn the principal residence into a powerful investment tool, particularly in areas enjoying significant price appreciation. If the taxpayer does not meet the ownership, use and frequency tests but sells the principal residence due to a change in location of employment, health issues or unforeseen events (such as divorce or birth of multiple children from the same pregnancy), a reduced exclusion may be available.
For example, Mr. and Mrs. Smith bought their home in 1985 for $200,000. They have made $50,000 in improvements, so their cost basis is now $250,000. They sell the home for $800,000, pay a six percent real estate commission ($48,000) and incur $15,000 in fix-up and miscellaneous selling-related expenses, resulting in a final effective sales price of $737,000 (sales price less selling costs). The gain on the sale is $487,000 ($737,000 less the $250,000 cost basis). Married, filing jointly and meeting the ownership, use and frequency requirements, Mr. and Mrs. Smith are able to exclude the entire gain from income taxes – not bad!
A home must be a principal residence to qualify for this valuable exclusion; vacation homes and rental homes do not qualify. However, if a vacation or rental home is converted to a principal residence and the rules detailed above are met, the owner passes the tax test.
Let’s say Mr. and Mrs. Smith also own a beach house and used it as a vacation home (no rental use). They purchased the home for $150,000, and it is now worth $650,000. Mr. and Mrs. Smith can sell their principal residence (as indicated above), move to the vacation home and convert it to their principal residence. As long as they live in the beach house for two years, they can sell it and pocket up to another $500,000 – tax-free! (Converting a rental property would trigger Section 1250 depreciation recapture tax on any amount depreciated.)
Military members also enjoy a special provision that allows those meeting the homeownership test to “suspend” the use requirement for up to 10 years if they experience a permanent change of station (PCS) move away from the home or are on qualified official extended duty for 90 days or more. The taxpayer must be serving more than 50 miles from the principal residence or living in government housing.
For example, Maj. and Mrs. Jones bought a house outside Fort Polk, La., in November 2004. They PCS to Fort Stewart, Ga., in December 2006 and decide to rent out their Fort Polk house. As long as they remain on active duty, they may suspend their use requirements on the Fort Polk property for up to 10 years (December 2016). If Maj. Jones retires in December 2012, the suspension period would end on his retirement and the Joneses then would need to sell the property within three years (December 2015) to qualify for personal residence treatment – even if they live in another house as their principal residence. (The Joneses still must pay Section 1250 tax on any amount depreciated while the property was in service as a rental.)
IRS Publication 3: The Armed Forces’ Tax Guide (pp. 11-12) and IRS Publication 523: Selling Your Home (page 13) explain these provisions in detail.