When homeowners sell their principal residence, they can exclude up to $500,000 in capital gains from income tax. The rules have been changed by the Housing Assistance Tax Act of 2008. The actual amount of the gain (profit) that results from the sale of the house that can be excluded is now based on the percentage of time when the house was used as a primary residence.
Homeowners who sell their primary residence can exclude up to a maximum of $250,000 (or up to $500,000 for married couples filing jointly) in capital gains from their taxes. The amount of gain that will qualify for the exclusion is limited based on the amount of time that the house is used as a primary residence. If the house is used other than as a primary residence, capital gains must be allocated between qualifying and non-qualifying use. Any non-qualifying use can potentially reduce the amount of capital gain that can be excluded. The allocation rules take effect beginning January 1, 2009.
Qualifying Use vs. Non-Qualifying Use
Taxpayers can qualify to exclude up to $250,000 in capital gains ($500,000 if married and filing jointly) when selling a house. To qualify, the person needs to own and live in the property has his or her primary residence for at least two years out of the five years ending on the date of sale.
Sometimes, however, the property isn't used as a primary residence during the entire five-year period. The house might be rented out, used as a vacation home, or used as a second home. Such uses of the home will be considered non-qualifying use and could subject gains from the sale of the house to tax.
Qualifying use means the property is being used by the homeowner or the homeowner's spouse as a primary residence. Non-qualifying use means the property is not being used as a primary residence by either the homeowner or the homeowner's spouse.
Note: Homeowners who have used their property exclusively as their primary residence (meaning, it was not used as a second home or as a rental during the 5-year period ending on the date of sale) will not need to allocate their gain.
Calculating Excluded and Non-Excluded Gain on the Sale of a Home
Gain from the sale of a home may need to be allocated between what gain be excluded and what gain is not excluded. The portion of capital gains that cannot be excluded is determined by the following ratio:
Period of non-qualifying use
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Period of ownership
You should make the computation using DAYS OF USE as the unit of measure.
Time Period of Non-Qualifying Use
For the purpose of calculating capital gains, the period of non-qualifying use is any period of time the property is not being used as a main home that begins on or after January 1, 2009. Non-qualifying use prior to January 1, 2009, is disregarded for the purpose of determining the capital gain allocation.
Temporary absences not exceeding a total of two years in aggregate will not jeopardize qualifying use. A property can maintain its status as a primary residence even if the homeowner is absence due to change in employment, health conditions, or other unforeseen circumstances.
Example of a Capital Gain Allocation
Dick and Jane buy a condominium in 2009. They already own a house which they use as their primary residence. They let their daughter Jen live there for the first two years while she attends graduate school. Jane moves into the condo in 2011 and makes it her primary residence for three years. Dick and Jane sell the condo in 2014 after owning the property for five years. During the five years that Dick and Jane owned the condo, there were two years of non-qualifying use when the property was not their primary residence. There were three years of qualifying use when Jane lived there as her primary residence. The ratio of non-qualifying use is 2 / 5, or 40%. Forty percent of the gain will be taxable capital gains, and the remaining 60% can be excluded from capital gains, up to the exclusion limit of $250,000 (or $500,000 for married couples filing a joint return).
Planning Tips for Non-Qualifying Use
In the past, tax professionals advised clients to sell real estate after living in their house for at least two years out of five years ending on the date of sale. This helped clients qualify for the capital gains exclusion because the exclusion was based on the last five years of ownership.
Now, however, the exclusion is based on the period of time when the property is used as a primary residence. Any other use will not be excluded and could trigger capital gains tax.
Taxpayers owning second homes, vacation homes, and rental properties will need to revise their capital gains strategy accordingly. The use test is applied for the time period beginning January 1, 2009, until the property is sold. To get the most tax benefit, the property will need to be used entirely as a primary residence during this time period.
Taxpayers planning to sell a second home may want to move in and make that property their primary residence starting January 1, 2009 (or as soon thereafter as possible), to gain as much qualifying use as possible before selling it.
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Top Ten Tax Facts if You Sell Your Home
Do you know that if you sell your home and make a profit, the gain may not be taxable? That’s just one key tax rule that you should know. Here are ten facts to keep in mind if you sell your home this year.
1. If you have a capital gain on the sale of your home, you may be able to exclude your gain from tax. This rule may apply if you owned and used it as your main home for at least two out of the five years before the date of sale.
2. There are exceptions to the ownership and use rules. Some exceptions apply to persons with a disability. Some apply to certain members of the military and certain government and Peace Corps workers. For details see Publication 523, Selling Your Home.
3. The most gain you can exclude is $250,000. This limit is $500,000 for joint returns. The Net Investment Income Tax will not apply to the excluded gain.
4. If the gain is not taxable, you may not need to report the sale to the IRS on your tax return.
5. You must report the sale on your tax return if you can’t exclude all or part of the gain. And you must report the sale if you choose not to claim the exclusion. That’s also true if you get Form 1099-S, Proceeds From Real Estate Transactions. If you report the sale you should review the Questions and Answers on the Net Investment Income Tax on IRS.gov.
6. Generally, you can exclude the gain from the sale of your main home only once every two years.
7. If you own more than one home, you may only exclude the gain on the sale of your main home. Your main home usually is the home that you live in most of the time.
8. If you claimed the first-time homebuyer credit when you bought the home, special rules apply to the sale. For more on those rules see Publication 523.
9. If you sell your main home at a loss, you can’t deduct it.
10. After you sell your home and move, be sure to give your new address to the IRS. You can send the IRS a completed Form 8822, Change of Address, to do this.