Several tax laws benefit home owners. One of them, perhaps the most generous, is an exemption from taxation on the profit from the sale of your principal residence. The rules associated with this exemption require minimum residency standards that focus on a two-year period. If you do not meet the residency requirement, you must pay tax on any profit generated by the sale of your home.
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Home Sale Exemption Rule
You are exempt from $250,000 of profit -- $500,000 for married couples -- on your principal residence providing you have both lived in and owned the house at least two of the five years prior to the sale. Interestingly, the two years do not have to have been consecutive not simultaneous with ownership. You could, for instance, have rented the house as a tenant for a year, moved away for two years, then bought the house and lived there for at least one of the two years you owned the home before selling it. You can use this exemption innumerable times, but not more often than once every two years.
Just because you have sold your house for more than you purchased it for does not necessarily mean you have a profit, called taxable gain in IRS terms. When you buy a property, the costs you incur on the sale, such as loan costs, are added to the price of the property and become what is called the home's "basis." If you make capital improvements to the property, like remodeling the kitchen, finishing the attic and adding a bathroom, those costs are added to your basis, then called your "adjusted basis." When you sell the property you incur more costs, such as sales commissions. These costs, along with your adjusted basis, are subtracted from the sale price to arrive at your taxable gain, or profit. It is this figure that is subject to taxation. If you meet the residency requirements for the exemption, the first $250,000 or $500,000 of profit is exempt from taxation. If you do not meet the residency requirements, all of the profit is subject to taxation.
How Much Will it Cost?
If you qualify for the exemption, profit over the exemption limit is taxed as long-term capital gains. The long-term capital gains rate is usually 15 percent but can be as low as zero for small gains. This is also the rate that applies to all profit for your residence if owned more than one year, but for which you have not met the residency requirements. If you owned your home for less than a year, the profit is taxed as a short-term capital gain. The tax rate is the same as the rate you pay on your regular income during the same tax year -- which will be between zero and 35 percent.
Pay on the Gain but Can't Write Off the Loss
Unfortunately, under IRS rules if you sell your principal residence at a loss, you cannot write off, or subtract, that loss from other capital gains or your income. When you sell at a loss one of three circumstances will apply: The first is a short sale, in which your lender agrees to accept less than what it is owed. In the second scenario, you pay the lender in cash whatever shortfall exists between the sales price and the mortgage. In the third scenario, the proceeds fully repay the lender but you still show a loss on the sale -- because you bought the house with a large down payment, paid down the loan, or paid for capital improvements while you owned the house.