If you sell your main home, the Internal Revenue Service lets you exclude up to $250,000 of the gain you make from your taxable income. This valuable concession means that most homeowners will not pay tax on the sale of their home. Before 1997, the exemption was a once-in-a-lifetime concession available only to seniors. Now, qualifying sellers can claim the exclusion repeatedly, as long as they have not excluded a home sale gain within the previous two years.
Exclusion Only Applies to Main Homes
In most cases, it is clear whether a property is the taxpayer's main home. For taxpayers with multiple properties, the IRS applies a number of criteria to determine whether the property is a main home and thus qualifies for the exclusion. The tax man will consider the amount of time you spend in the property, where other family members live, where you work and the address you use for your voter registration, driver's license and bills before making an assessment. Gains made on the sale of second homes and investment properties are subject to capital gains taxes at prevailing rates.
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Tests for Ownership and Use
To exclude a gain, a taxpayer must both own and use the home as his principal residence for at least two of the five years immediately preceding the sale. Those two years do not have to run concurrently. For example, you could live in the property for a year, rent it to tenants for two years, and then move back in for another year. Provided these events take place in the five years leading up to the sale, you can still claim the home sale exclusion. Tax law provides an exception to the two-year rule if the homeowner is forced to sell for health reasons, because his place of work has moved more than 50 miles away, or for other unforeseen circumstances such as death or divorce.
Figuring Out Your Gain
To calculate your gain, first deduct your selling costs from the sale price. From this figure, deduct the price you paid for the home when you bought it, together with your purchase costs such as title fees, legal fees, survey fees, recording fees, title insurance and stamp taxes. You can also deduct the cost of any improvements you made to the property during your period of ownership. The resulting figure is your gain. The IRS requires you to keep records proving your calculations for at least three years after the sale.
What the Exclusion’s Worth
At the time of publication, you can exclude the gain you make on your home sale or $250,000, whichever is the lower. Married couples who file joint returns can exclude up to $500,000. The maximum exclusion assumes that you have lived in the home for two years. Home sellers who have lived in the home for a lesser period receive a corresponding proportion of the exclusion. For example, a seller who moves away after just one year for health reasons may exclude up to half the maximum gain, or $125,000.
Don't Forget the Paperwork
Most home sellers will not have to report their tax-free windfall to the IRS. If you can exclude all of your gain, you don't need to report the sale on your tax return. Taxpayers who can only exclude part of the gain must report the gain on Form 1040 Schedule D. Use the guidance notes to help you calculate your gain and fill out the form. If the IRS sends you Form 1099-S or any other informational income reporting document, you must also report the sale even if you can exclude the gain.