How to Make Home Sale Gains Tax Free

The tax rules for selling a home are generous, but not generous enough for many homeowners on the coasts and in resort areas. Many of these homeowners have gains that exceed the tax free amount. Knowing the ins and outs of the rules can boost your tax-exempt gains. Owners of more than one home also can shield more gains by knowing the rules.

Under current rules, a single person can exclude up to $250,000 of gains from the sale of a principal residence; a married couple can exclude up to $500,000 of gains. The sellers must have owned the home and used it as the principal residence for at least two of the five years immediately preceding the sale. The ownership and principal residence years do not have to coincide.

The gains from the sale of the home are the difference between the selling price (minus selling expenses) and the tax basis of the home. The basis includes more than the original cost of the home. It also includes permanent improve-ments, such as expansions and upgrades. Anything that increases a home’s value or extends its useful life is an improvement. But repairs that maintain the good condition of a home or keep it in working condition are maintenance and do not increase basis. Some of the costs of buying the home also increase the basis. These include abstract fees, charges for installing utility lines, legal fees (including a title search and preparation of the sales contract and deed), recording fees, survey fees, transfer taxes, and title insurance. More details are in IRS Publication 523.

Keeping a good record of your tax basis reduces taxable gains. But if you cannot verify and prove the expenditures, you won’t be able to increase the basis and reduce taxable gains.

The current rules, enacted in 1997, do not require gains to be rolled into a new home, impose an age requirement, or limit the number of times the exclusion can be used. The real limit is that the full exclusion cannot be used more than once every two years (unless there is an unexpected change in circumstances). The repeal of the old lifetime limit and age requirement provides planning opportunities for homeowners.

One possibility is serial homeownership. Buy a home and make it your principal residence for at least two years. During that time fix it up, or let it appreciate if you are in a hot market. Sell, pocket your tax-free gains, and re-start the process.

Another opportunity is for owners of more than one home. After establishing one home as the principal residence for at least two years, sell it and take the gains tax free. Then, establish the other home as the principal residence for at least two years. After that, it can be sold for tax free gains up to the limit. The result is the gains from both homes are cashed out tax free.

The trick in these cases is to ensure that a home is the principal residence. The term is not precisely defined in the law or regulations. The principal residence generally is where the taxpayer spends most of the year, but other facts and circumstances can be considered when the IRS believes those are a better indicator.

A court case in 2003 created another requirement. It said the principal residence is where the taxpayer spends at least half the time. The test is determined separately for each year. That means if an owner of multiple homes does not spend at least six months in one home during the year, there is no principal residence for that year. A homeowner who does not spend at least six months in one home in any year won’t be able to exclude gains from the sale of any of the homes.

To ensure exclusion of gains, an owner of multiple homes should be able to prove where time was spent for at least the two years before a sale, and those records should prove that the home sold was the principal residence. This can be done through a calendar, diary, log, or perhaps telephone bills and similar records. Keep in mind that RVs, boats, and anything with sleeping, kitchen, and toilet facilities can be considered a home.

Taxpayers with deductible home offices get special treatment. In the past, the depreciation deductions on the business portion of the home reduced the tax basis. In addition, the sale had to be treated as two separate transactions: a taxable sale of business property and the sale of a principal residence.

The IRS changed the rules a few years ago. The tax basis of the home still is reduced by the depreciation deductions. But the sale of the home is not treated as two separate assets as long as the office portion is not a separate structure. The gain from the entire home can qualify for the exclusion.

But the depreciation deductions or appreciation might boost gains above the exempt amount. In that case, the owner should consider two separate transactions. In one, the office portion of the home is exchanged for another business or investment property, such as a rental condo. This gain is tax deferred by the exchange. There are no taxes on the gain from that portion of the home if the new property is used as a business or investment property. Gains are taxed only when the new property is sold.

The residential portion of the property qualifies for the home sale exclusion. You generally have to use a broker experienced in tax-free exchanges to make this transaction work within the tax rules. In addition, any mortgage on the home complicates things and could cause part of the gain to be taxed.

Here is another situation in which the home sale exclusion can be used with some creativity.

Suppose you do not own a typical suburban home with a compact lot. Instead, your home is surrounded by some acreage. The property has appreciated, and you are interested in subdividing the property and selling the land in lots. The IRS regulations state that in this case the gain from each lot qualifies as part of the home sale exclusion if the lot is sold within two years before or after the sale of the principal residence. If the timing works, you can exclude gain from all the lots and from the residence. But there is only one exclusion amount, not a separate $250,000 limit for each lot.

With some of these strategies, you should consult with a tax expert to be sure of meeting all the detailed requirements. In addition, many details of the home sale exclusion are in IRS Publication 523, available free on the IRS web site or by calling the IRS.

Homes have appreciated significantly since the tax-free limit was established in 1997. But homeowners who follow the rules can squeeze more tax-free gains out of their homes.