This is a common question but one that arises from an expired law. The new question is, "How much profit am I entitled to when I sell my house?" Since 1997, and still in play as of 2010, you can take quite a bit of profit from the sale of your home without having to pay any tax and without having to reinvest the profits.
Immediately before passage of the 1997 Taxpayer Relief Act, to defer taxes on the profit realized from selling your home you had to reinvest it in a new home within a relatively short period of time. The new home also had to cost more than the one you sold. If you were over 55 you could sell without following these guidelines and take $125,000 of the profit without having to pay taxes. The Taxpayer Relief Act changed those rules. Both the pre- and post-1997 rules apply only to your home. Different rules apply to rental property.
Home Tax Exemption
The 1997 Taxpayer Relief Act allows you to take $250,000, if you are single, or $500,000, if you are married, of profit from the sale of you home without paying any tax. You do not have to buy a replacement home, although you can if you want to. It does not affect tax liability one way or the other.
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Residency and Occupancy Requirements
To make use of the home tax exemption, you must have owned and lived in your home two of the last five years before the sale. The two years do not have to be continuous nor do the terms of ownership and occupancy have to be simultaneous. For example, if you lived in the home while renting it from another party for two years, then purchased the home but lived somewhere else for the next two years, you meet the two requirements.
To determine the profit on your home sale, subtract the purchase price, plus all expenses associated with both the purchase and sale, along with the cost of capital improvements you have made to the house, from the sale price. Capital improvements are improvements that add value to the property and have a useful life of more than one year. Common examples include kitchen remodels, a new furnace and new windows.
After excluding the $250,000 or $500,000 in tax-free profit, the balance of the profit from the sale of your home is taxed at long-term capital gains rates. As of 2010, the highest long-term capital gains rate was 15 percent, substantially more favorable than the ordinary income tax rates, which step up to 35 percent.