Avoiding Capital Gains Taxes When Selling Your Main Home
Avoiding Capital Gains Taxes When Selling Your Main Home
Capital gains when selling a house can be a big concern and should be planned for accordingly. In this article we’ll go over the tax rules when selling your main home. The section 121 exclusion makes it so that you can avoid capital gains tax depending on your situation. We’ll go over that potential as well as other tax considerations when selling your home.
What is the Section 121 Exclusion for the Sale of Your Main Home?
The section 121 exclusion allows many taxpayers to exclude the gain on sale of their main home. That means that in those situations, capital gains when selling a house are avoided. In the case of single filers, up to $250,000 of the gain can be excluded. For joint filers that number goes up to a $500,000 exclusion. If the taxpayer is able to exclude all of the gain on their main home, no reporting is required. However, if the taxpayer receives Form 1099-S the gain should be reported on the tax return, even while remaining non-taxable.
What Properties Qualify For the Exclusion?
The exclusion applies to your main home, regardless of the property type. It can be a traditional home, a mobile home, boat house, apartment etc. The property must furthermore have a kitchen, bathroom, and sleeping area to qualify as your main home.
What Are the Eligibility Requirements for the Exclusion?
In order to qualify for the exclusion, the taxpayer must meet certain eligibility requirements and tests. These are:
- The taxpayer must have sold their main home
- Cannot have excluded capital gain of a main home in the two years right before selling their current home (with some exceptions which we’ll cover)
- The taxpayer must meet the use and ownership tests
The Ownership and Use Tests for Section 121 Exclusion
The ownership test and the use test for section 121 are separate tests where the time periods do not need to be consecutive. The IRS will figure out each test separately.
At the end of the five year period before the sale of the home:
- Ownership test: the taxpayer must have owned the home for at least two years.
- Use test: the taxpayer must have lived in the home for at least two years.
Again, the two years do not have to be consecutive. Meaning, as long as the taxpayer has owned/lived in the home for 730 days (two years) during the five-year period, they qualify for the exclusion. Since ownership and use are two different tests, the two-year qualification for each doesn’t need to be the same period. As long as both fall within the last five years, each test will independently apply even if they’re different periods.
In addition, temporary absences from the main home, such as vacations, still count for “use.” Even if the home is rented out, if it’s a short absence the period will still apply for the use test.
Exceptions and Reduced Exclusions
If you’d already used it in the two-year period before the current sale you might still get a reduced exclusion. The same goes for the taxpayer who did not own/used the home in the two-year period.
If the sale of the home occurred due to unforeseen circumstances, you might be eligible for the reduced exclusion. Unforeseen circumstances include:
- A job change (applies if the new job is at least 50 miles further from the old home than was the previous place of the job. If there was no prior place of employment, then the new job must be at least 50 miles away from the old home)
- Twins or more from a pregnancy
- Damage to the old home due to disaster, war, or terrorism
- Health issues arising for the taxpayer, spouse, or related individual (child, relative, etc.)
- Divorce, legal separation, or death
- An involuntary conversion of the property or condemnation
The calculation for the reduced exclusion is to multiply the full exclusion amount by a fraction. The fraction will have as it’s denominator the total days or months of two years (730 days or 24 months). For the numerator you take the total number of days or months that:
- You owned and used the home to live in during the five year period right before the sale
- Passed after you last sold your previous home and utilized the exclusion within two years prior to selling and attempting to use the exclusion again
Example of Using the Reduced Exclusion
For example, let’s say you’re a joint filer and selling your main home with a $300,000 gain. You did not meet the use and ownership test. You owned and lived in your main home for one-and-a-half years before selling it.
However, you’re selling because your wife just gave birth to two beautiful twin baby girls. Congratulations! On your new family and also on qualifying for the “reduced” exclusion. Let’s see how this fleshes out:
The full amount of the exclusion would be $500,000 since you’re a joint filer with your spouse. Since you only lived one-and-a-half years in the home, you will qualify for
18/24 * $500,000 = $375,000
75% * $500,000 = $375,000
Therefore, even though you did not qualify for the full $500,000, since the capital gain was only $300,000 you have no capital gains tax. The reduced exclusion of $375,000 will cover your $300,000 gain.
- Other Special Considerations For The Exclusion
Some other points to not is that married couples may only exclude the $500,000 if they file a joint return. If they file separate returns, only the spouse that “owns” the house may use their respective $250,000 single-filer amount. On the other hand, if filing jointly, only one spouse is required to own the house in order to claim the full $500,000 amount.
Unmarried Individuals Owning and Living In a Home
Another scenario is if two unmarried individuals own a home and live together. In that case each make take their respective $250,000 exclusion subject to all the ordinary tests.
Because military personnel often move, the five-year period is suspended for up to ten years. This will make them more likely to be able to qualify for the exclusion. It extends the period in which the ownership and use test can apply.
Members of the U.S. Army, Navy, Air Force, Marine Corps, etc. all apply to this treatment.
I hope you were able to see how the section 121 exclusion can benefit you when selling your home. Avoid capital gains when selling a house as much as possible. A good pro-active tax strategy can save you tens and hundreds of thousands. Work with your accountant to plan for all this in advance.
For more help in your tax and accounting situation for you and your business, go here to schedule a free consultation: https://odysseytaxes.com/contact-tax-preparer/. For more articles on similar subjects make sure to check out our blog posts here: https://odysseytaxes.com/blog-posts/.