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The home-sale gain exclusion break can be one of the best tax-saving deals of your life. But timing is important.
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The pandemic has created an economic downturn, but that hasn’t slowed some housing markets. Great if you’re a seller. But what about taxes?
If you sell your main home for a healthy profit, the federal income tax home-sale gain exclusion can be one of the most valuable tax breaks on the books. You can potentially exclude (pay no federal income tax on) up to $250,000 of home-sale profit or up to $500,000 if you’re a married joint-filer. Good.
Here’s the second installment of our two-part series on how to take advantage. For Part 1, see this previous Tax Guy.
Qualification rules
Singles can exclude home-sale gains up to $250,000 and married joint-filing couples can exclude up to $500,000. However, you must pass the following tests to be eligible.
Ownership test
You must have owned the property for at least two years during the five-year period ending on the sale date. Two years means periods aggregating 24 months or 730 days.
Use test
You must have used the property as your principal residence for at least two years during the same five-year period.
Periods of ownership and use need not overlap. For example, you could rent a house and use it as your principal residence for Years 1 and 2 and then buy it and rent it out to others for Years 3 and 4. If you sold the house in Year 5, you would pass both the ownership and use tests and qualify for the gain exclusion privilege.
Joint-filer test
To qualify for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.
Anti-recycling rule
If you excluded an earlier gain within the two-year period ending on the date of a later sale, you are ineligible for the gain exclusion break for the later sale. In other words, the gain exclusion privilege cannot be “recycled” until two years have passed since you used it last.
Joint filers with one home
To qualify for the larger $500,000 joint-filer gain exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test. When only one spouse passes both tests, the maximum gain exclusion is only $250,000. However, if you and your spouse own two houses, you can each potentially separate $250,000 exclusions.
Example 1: Say you get married and immediately sell your valuable home, which you had owned and used as your principal residence for many years, for a whopping $600,000 gain. You then file a joint return for the year of sale with your new spouse. Unfortunately, you do not qualify for the larger $500,000 joint-filer exclusion, because your spouse does not pass the use test. Therefore, you must report a $350,000 taxable gain ($600,000 profit – $250,000 exclusion) on your return for the year of sale. Ouch.
Tax-saving strategy: Instead of selling immediately, you and your new spouse should consider living in your home for at least two years after the marriage. That way, you will qualify for the larger $500,000 joint-filer, because you will pass the ownership test and both you and your spouse will pass the use test.
Joint filers with two homes
If you own two homes and file jointly, each spouse’s eligibility for the $250,000 exclusion is determined separately, and each spouse is considered to own each property for any period the property is actually owned by either spouse. Actual ownership doesn’t matter as long as you file jointly.
Example 2: You and your spouse have a commuter marriage and own two homes. You work in L.A. and live most of the time in a condo there. Your spouse works in D.C. and lives most of the time in a townhouse there. The larger $500,000 joint-filer exclusion is not available for either home, because both you and your spouse must pass the use test to qualify for the bigger exclusion. However, two separate $250,000 exclusions are potentially available in this situation. Here’s how that would work.
Assume both homes have been owned for more than a few years. As long as you file jointly in the year when a home is sold, the ownership test will be passed for that home, regardless of whether the home is owned jointly or separately. That’s because, as stated earlier, each spouse considered to own a property for any period the property is actually owned by either spouse. So, if you sell the L.A. home, you pass both the ownership test and the test for that property. If the D.C. home is sold, your spouse would pass both tests for that property.
So, on a joint return, you would qualify for a $250,000 exclusion if you sell the L.A. home. Your spouse would qualify for a separate $250,000 exclusion if the D.C. home is sold. This would be true whether you sell both homes in the same year or in separate years.
Married but filing separate returns
If you and your spouse file separate returns, it gets more complicated, but you can still potentially qualify for two separate $250,000 exclusions. In the separate return scenario, actual ownership matters.
If you and your spouse own a property jointly and you both live there, you can potentially exclude up to $250,000 of your share of the gain on your separate return if the property is sold. Your spouse can do the same.
If you and your spouse own two properties separately and live in them separately, you can potentially exclude up to $250,000 of gain on the sale of your property. Your spouse can do the same on the sale of his or her property.
Surviving spouse
If your spouse died and you have not remarried, you cannot file a joint return for any year after the year in which your spouse died. Not too long ago, this little rule could have prevented you from taking advantage of the larger $500,000 exclusion that is allowed to joint filers, because you would have been limited to the smaller $250,000 single-filer exclusion if you sold your home in a year after the year in which your spouse died. Our beloved Congress addressed this problem but did not completely cure it.
Under today’s rules, an unmarried surviving spouse can claim the larger $500,000 gain exclusion for a principal residence sale that occurs within two years after the spouse’s date of death, assuming all the other requirements for the $500,000 exclusion were met immediately before the spouse died. Beware: since the two-year eligibility period for the larger exclusion begins on the date of the spouse’s death, a sale that occurs in the second calendar year following the year of death but more than 24 months after the date of death won’t qualify for the larger $500,000 gain exclusion. You have to get the timing just right to qualify.
Reduced gain exclusion when you don’t meet all the timing rules
What happens when you fail to meet all the aforementioned qualification rules? For example, you might sell your home for a healthy profit after living there only 18 months instead of the required two years. Or you might sell your current home less than two years after excluding gain from the sale of a previous residence. Must you pay tax on the entire gain when you make such a “premature” sale? Not necessarily. IRS regulations allow you to claim a reduced exclusion (some fraction of the full $250,000 or $500,000 amount) in quite a few circumstances.
The reduced exclusion equals the full $250,000 single-filer or $500,000 joint-filer exclusion (whichever applies) multiplied by a fraction. The numerator is the shorter of: (1) the aggregate period of time the property is owned and used as your principal residence during the five-year period ending on the sale date or (2) the period between the last sale for which you claimed an exclusion and the sale date for the home currently being sold. The denominator is two years (12 months or 730 days). That sounds more complicated than it really is. Here are some clarifying examples.
Example 3: You and your spouse file jointly. Due to a job change that required a long-distance move, you sold your home, which you had owned and used as your principal residence for 11 months. Because you bought at exactly the right time, you snagged a $200,000 gain. You are entitled to a reduced gain exclusion of $229,167 ($500,000 x 11/24). So, you can exclude the entire gain for federal income tax purposes.
Example 4: You sold your previous home 15 months ago and claimed the gain exclusion privilege. Due to health reasons, you are now about to close on the sale of your current home, which you’ve owned and used as your principal residence for 15 months, for a $125,000 gain. You are entitled to a reduced gain exclusion of $156,250 ($250,000 x 15/24). So, you can exclude the entire gain for federal income tax purposes.
Eligibility for reduced exclusion
The reduced exclusion deal is only available when you sell your home due to:
* A change of place of employment.
* Health reasons.
* Other unforeseen circumstances, as specified by the IRS.
For details on eligibility for a reduced exclusion, see IRS Publication 523 (Selling Your Home) at www.irs.gov.
The bottom line
As I said at the beginning, the home-sale gain exclusion break can be one of the best tax-saving deals of your life. And you can qualify in some circumstances that might surprise you.
