Homeowners Tax Break: Capital Gains Exclusion

Homeowners already know the many tax breaks that Uncle Sam offers, most notably mortgage interest and property tax deductions. However, there is another tax break that is excellent but not as well known: When you sell your primary residence, you can make up to $250,000 in profit if you’re a single owner, twice that if you’re married, and not owe any capital gains taxes.

What is capital gains tax?

Capital gains tax, is a tax imposed on the profit (capital gains) resulting from the sale of an investment. For example, capital gains are commonly realized after the sale of stocks and property. To calculate capital gain, subtract the purchase price from the sales price.

Sale price – purchase price = capital gain

Still some requirements to meet

There’s no limit on the number of times you can use the home-sale exemption. In most cases, you can make tax-free profits of $250,000, or $500,000 depending on your filing status, every time you sell a home.

There are a few rules to follow, of course. First, the property you’re selling must be your principal residence. That means you live in it. This tax break doesn’t apply to a house or other property that you have solely for investment purposes.

You also must live in that principal residence for two of the five years before you sell it. This is known as the use test. It also means, practically speaking, each sale must be at least two years apart.

That still leaves you room to make some money on several properties. You can sell your residence this year, pocket any gain within the tax limits and buy a new residence. Then two years later, you can do the same thing, again and again, every two years.

Special rules for married couples

While spouses get double the exclusion of single home sellers, couples also have some additional considerations when it comes to determining whether their sale is tax-free.

Either spouse can meet the ownership test. For example, the IRS says it’s OK if you owned the home for the past two years, but you just added your new spouse to the title when you got married six months ago. Since you owned the residence for the requisite time, you have no problem meeting the ownership test even though your spouse wasn’t an official owner for that long.

However, both spouses must pass the use test; that is, each must live in the residence for two years. But the shared use doesn’t have to be while you file jointly. If you and your now-spouse shared the home for one and a half years before tying the knot and then six months as newlyweds, the IRS will allow you to claim the exemption. But if your better half didn’t move in until the wedding day, you’re out of tax-exclusion luck.

Under the couple requirement, if either spouse sold a home and used the exclusion within two years of the sale of any jointly owned property, the couple can’t claim the exclusion.

That means if your new spouse sold his or her town house a month before the wedding, then you’ll have to wait two years after that property’s sale date before you can dispose of your shared marital residence totally tax-free.

In some cases, a couple might be able to exclude some profit from taxation, but not the full $500,000 allowed joint filers, based on one spouse’s eligibility qualifications.

To arrive at your gain amount, you first must establish your basis in the home. This is what you paid for the residence and all capital improvements you’ve made, such as adding a room or finishing a basement.

Then you compare that basis amount to what you get from the sale, less your commissions and other expenses. When you subtract your cost basis in the residence, this will give you the amount of gain on the sale.

In most instances, sellers will find they made a nice profit, but not one large enough to trigger a tax bill. Some, however, could find their residences appreciated so much that the great sales prices they got ended up costing them at tax time. That’s why it’s important to accurately track anything that could affect your home’s cost basis.

The improvements increase your basis, so a smaller portion of the selling price would be viewed as gain. Any overage is taxed at the applicable long-term capital gains rates, which is 20 percent for higher-income taxpayers, 15 percent for most individuals and, for some sellers, zero percent.

Special rules for special circumstances

Members of the military also get special home-sale consideration. Because of redeployments, soldiers often find it hard to meet the residency rule and end up owing taxes when they sell.

But a law change in 2003 exempts military personnel from the two-year use requirement, for up to 10 years, letting them qualify for the full exclusion whenever they must move to fulfill service commitments.

Another law change, this one beginning in 2008, takes into account the special circumstances that a homeowner faces when selling after a spouse dies.

Previously, to exclude the full profit amount allowed married homeowners when they sell, the surviving spouse had to sell the property in the same tax year that the husband or wife passed away. But now, an unmarried widow or widower has up to two years to sell the home and not face taxes on up to $500,000 in profit.

Bottom line:

The home sale capital gain exclusion is another great benefit for owning a home. Knowing the rules and keeping track of expenses over the years can end up saving you big money when selling a house.

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