The tax rules for selling a personal residence seem to generate more widespread misunderstanding than most other parts of the tax code.
The rules themselves are fairly simple as tax code provisions go. One problem seems to be that many people looking to sell homes don’t realize that the rules were overhauled in 1997. Another problem is that an early version of the Tax Cuts and Jobs Act (TCJA) in 2017 would have overhauled the rules again and received a lot of publicity. But the final version of the TCJA left the home sale rules unchanged.
The 1997 law greatly simplified the tax rules for home sales. The amount of gain you exclude from income has no relation to the amount you rollover into another home purchase. In fact, there’s no requirement that you use the proceeds to buy another home in order to exclude the gain.
Also, your age is not a factor in the amount of gain you exclude. Under the old law, taxpayers ages 55 and over could exclude gains that other taxpayers couldn’t.
Under the current rules, when a taxpayer sells a primary residence, he or she can exclude the first $250,000 of gain from gross income. Married couples filing jointly can exclude the first $500,000 of gain. Any gain that exceeds the exclusion amount is taxable as a capital gain.
(Losses aren’t deductible, because it is a personal use asset, not an investment or business asset.)
There’s no limit on the number of home sales or the amount of gain that can be excluded from income during your lifetime.
There are a couple of rules designed to prevent speculators from earning tax free gains from home flipping. You must have both owned and used the home as a primary residence for at least two of the five years immediately preceding the sale. The ownership and residence periods don’t have to be concurrent and don’t have to be the two years immediately preceding the sale. That gives some flexibility to people who need to move out of a home but don’t sell it for a few years.
The exclusion also can be used only every two years. When a home is sold for a gain before two years have passed since the last home sale at a gain, the amount of gain you can exclude is pro-rated based on how much time has passed since the exclusion was last used.
For married couples, the $500,000 exclusion amount is available even if only one spouse was the home’s owner. But both spouses must have lived in the home as a primary residence for at least two of the five years or the exemption is only $250,000.
The exclusion applies only to your primary residence. It doesn’t apply to sales of second homes, vacation homes, or rental properties. Sales of secondary residences are subject to capital gains taxes.
Here’s a strategy that works for owners of two or more homes who wish to sell both and maximize the excluded gain.
First, sell your primary residence and exclude the gain from income. Then, move into the second home and establish that as your primary residence for at least two years. At that point, you can sell the second home and exclude that gain up to the limit.
Remember that there’s no requirement to roll over the proceeds to another home. The gain from a sale is tax free regardless of what you do with the money. That allows a home seller to downsize or move to an area with lower housing prices and invest part of the sale proceeds.
When a spouse dies, the surviving spouse has two years to sell the home and take the $500,000 exclusion, provided they met the two-year ownership and residence requirements at the time of the first spouse’s passing. If the house isn’t sold within two years of the first spouse’s passing, then the exclusion amount is reduced to $250,000.
Remember that the gain from the sale of a home is computed by deducting your tax basis in the home from the amount realized from the sale. The basis includes the cost of improvements to the home, as well as the original cost. So, don’t forget to add the cost of any improvements you made to the basis before computing the amount of your gain.