So, while prospective sellers are making their properties look like model homes in the hopes of raking in a nice profit, this is a good time to review how taxes will factor into the transaction. With the home sale gain exclusion tax break, the profit from selling your principal residence might be free from federal income taxes (and possibly state income taxes, too). The rules are straightforward for most sellers.
Basic Qualifications
An unmarried homeowner can potentially sell a principal residence for a gain of up to $250,000 without owing any federal income tax. If you're married and file jointly, you can potentially pay no tax on up to $500,000 of gain. To qualify, however, you generally must pass two tests.
Ownership Test. You must have owned the property for at least two years during the five‑year period ending on the sale date.
Use Test. You must have used the property as a principal residence for at least two years during the same five‑year period (periods of ownership and use need not overlap).
To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
If you excluded a gain from an earlier principal residence sale under these rules, you generally must wait at least two years before taking advantage of the gain exclusion break again. If you're a joint filer, the $500,000 exclusion is only available when neither you nor your spouse claimed an exclusion for an earlier sale within two years of the sale date in question.
Tip: If you make a "premature" sale that fails to meet the preceding timing rules, don't give up hope. You may qualify for a reduced exclusion that will be large enough to shelter your entire gain from federal income tax as described below.
Reduced Exclusion May Apply to "Premature" Sales
You generally cannot claim the federal home sale gain exclusion break if you fail either the ownership test or the use test explained in this article. Also, you generally cannot claim an exclusion for a sale that occurs less than two years after an earlier sale for which you claimed an exclusion.
The keyword here is generally, because there's a favorable exception that might help when you make a "premature" sale that fails to meet the basic timing rules. Specifically, you can claim a reduced exclusion if your premature sale is primarily due to:
- A change in place of employment.
- Health reasons.
- Certain unforeseen circumstances outlined in IRS regulations.
For example, let's say you and your spouse own and use a home as your principal residence for 18 months. You are forced to sell because your job is transferred to a distant state. Under these circumstances, you would qualify for a reduced gain exclusion of $375,000. This is 75 percent of the full $500,000 joint-filer exclusion, because you owned and lived in the home for 75 percent of the required two-year period.
Bottom Line: If you qualify for the reduced exclusion, it can be generous enough to completely shelter your profit from federal income tax.
Beware if You Engaged in a Tax-Free Rollover Under Old Law Rules: Back in the days before the current gain exclusion break existed, did you avoid paying federal income tax by rolling over a home sale gain into the basis of the residence you are now about to sell? Watch out if you did.
The gain on your current residence may be much higher than you think. Why? Because the profit you rolled over under old law (before May 7, 1997) reduces the tax basis of your present home for gain calculation purposes.
Example: Let's say you and your spouse rolled over a $350,000 gain from a 1995 home sale into the basis of your current home, which cost $550,000. You're now getting ready to sell that home for an expected $975,000. You may think your gain will be only $425,000 ($975,000 sale price minus $550,000 cost). That $425,000 gain would be federal-income-tax-free, thanks to the generous $500,000 joint-filer exclusion. Unfortunately, it's not quite that simple. The correct gain for tax purposes is $775,000 ($975,000 sale price minus $550,000 cost basis plus the $350,000 gain rollover that you did under the "old law"). So, even if you qualify for the full $500,000 joint-filer exclusion, you would still have a taxable profit of $275,000 ($775,000 gain minus $500,000 exclusion). Even so, this is hardly bad news, because it means you made lots of money on your two home sales.
In most cases, the federal home sale gain exclusion rules are generous and fairly simple. However, as with all tax breaks, things can get complicated if your situation is the least bit out of the ordinary. Your tax adviser can tell you if your home sale transaction will be free from federal income tax and help you plan for the best tax results.