Making Capital Gains Taxes Disappear on a Profitable Home Sale

Sandy Botkin
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Possibly one of the biggest tax breaks on the books is for the sale of a principal residence. Gains of up to $500,000 ($250,000 for single filers and married filing separately) are tax-free. Even better, homeowners can “recycle” this generous break every two years. 

NOTE: The exclusion doesn’t apply to any depreciation taken after May 6, 1997 in case the property was a rental property or was a partial home office.

To qualify for the exclusion, you must own and use the home as your main residence for at least two out of the five years preceding the sale of the home. However, failure to meet this holding period doesn’t completely eliminate the exclusion as long as the sale is forced due to a job change, divorce, health reasons or certain other unforeseen circumstances. For example, there was a case of a taxpayer who owned a home for one year when a new neighbor (policemen) moved in with his police dog. The dog barked most of the night forcing the taxpayer to move. The court held this was an unforeseen circumstance that helped avoid the two- year requirement. 

If, however, you don’t meet the two- year requirements due to a hardship, you will get prorated partial exclusion. Thus, if you sold the home due to an unforeseen circumstance after living in it only one year, you would get 50% of the exclusion since you only met 50% of the requirements. 

What happens if you are now getting married and one of you sell their own home, such as the husband selling his home? He can claim $250,000 exclusion on that home. Also, the wife can also sell her home and claim $250,000 exclusion and then move into a newly bought home where the new time limits start again.

If you and your spouse are thinking of buying a “fixer-upper,” the tax benefits are enticing. You can live in the house for two years, complete the renovation and wind up paying no federal taxes (and usually no state taxes) on gains up to $500,000. Then you can buy another house and do it all over again!!

NOTE: use of the home for non-qualified use, is not eligible for the gain. Non-qualified use might be use as a second home, vacation home, rental property etc. The portion attributable to non-qualified use is determined on a prorata basis. 

Example: Mark and Lynn could exclude up to $500,000 of gain from tax. if three years were used as a second home out of the five years of ownership 60% of the gain counts as non-qualified use. Thus, only 40% of the gain– or $200,000– qualifies for the exclusion.

Finally, gain is determined by the sales price less your basis. Basis is original cost ( less any depreciation taken) PLUS improvement. Thus, if you make in improvements to your home such as a home addition, new heating or air conditioning system, new roof etc. keep records of this since they will increase your basis.

Hopefully, this post will answer most of the issues that you should know in order to maximize your home exclusion.

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