For all the obvious reasons, many suburban real estate markets are red hot. In these seller’s markets, big home-sale gains are likely. 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 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 first installment of our two-part series on how to take advantage.
Gain exclusion 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.
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.
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 home 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 then sell the place in Year 5, you would pass both the ownership and use tests and qualify for the gain exclusion privilege. Who knew?
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.
What counts as a principal residence?
This can be a good question if you own and occupy several residences. The general rule says your principal residence for the year is the one where you spend the majority of time during that year. According to IRS regulations, other relevant factors can include:
- The mailing address used for your bills and correspondence.
- The address shown on your income tax returns, driver’s license, and auto and voter registration cards
- Where you maintain your bank accounts
- Where you maintain religious affiliations and club memberships.
- Where family members live.
Example 1: You own one home in New York and another in Florida. During 2016-2020 (five years), you spend seven months each year in the New York home and the remaining five months in the Florida home. You sell both properties in January of next year. Barring unusual circumstances, the New York home is considered your principal residence, and you can claim the gain exclusion privilege only for that property. This is the case even though you spent about 25 months in the Florida home during the five-year period ending on the sale date (more than the requisite 24 months).
Despite what you might conclude from the preceding example, the following example illustrates that it is indeed possible to pass the ownership and use tests for two residences at the same time.
Example 2: You own one home in Michigan and another in Arizona. During 2017 and 2018, you live in the Michigan home. During 2019 and 2020, you live in the Arizona home. If you sell either home in 2021, you would qualify for the gain exclusion privilege because you pass the ownership and use tests for both homes. However, if you sell both in 2021, you cannot claim gain exclusions for both sales. That’s prohibited by the anti-recycling rule explained immediately below.
Beware of anti-recycling rule
The other big qualification rule for the home sale gain exclusion privilege goes like this: the exclusion is generally available only if you have not excluded a gain from any earlier sale occurring within the two-year period ending on the date of the later sale. In other words, the gain exclusion privilege generally cannot be “recycled” until two years have passed since you used it last.
For married couples, the larger $500,000 joint-filer exclusion is only available when neither spouse excluded a gain from an earlier sale within the two-year period.
Example 3: You sold your previous principal residence on July 1, 2019, and excluded the gain on your 2019 Form 1040. Before selling that home, you purchased another property and began using it as your new principal residence on January 1, 2019 (six months earlier). You sell the second principal residence on March 1, 2021, thinking you’ll qualify for the gain exclusion break on that sale too. Wrong. While you pass the ownership and use tests with flying colors, the March 2021 sale violates the anti-recycling rule, because it’s within two years of the July 2019 sale. Therefore, you’re ineligible to exclude any gain from the 2021 sale.
However, if your profit from the 2021 sale is bigger than the profit from the 2019 sale, you can amend your 2019 return and choose on the amended return to forego the gain exclusion break for the sale in that year. Then you can claim the gain exclusion break for the more-profitable 2021 sale.
The bottom line
As I said at the beginning, the federal home-sale gain exclusion deal can be one of the most valuable personal income tax breaks on the books. In my next column, I’ll supply more details on how married homeowners can cash in and explain how you may be eligible for a reduced exclusion when you fail to meet all the qualification rules for the full exclusion. Stay tuned.