When selling your principal residence, the basic tax rule is that you can exclude gains of up to $250,000 if you are a single taxpayer and $500,000 if you are a married taxpayer filing jointly, provided the home was your primary residence in at least two of the preceding five years. This exclusion can be used once every two years. While this rule seems fairly straightforward, there are a number of special situations to keep in mind:
- Your gain also includes deferred gains from the sale of previous homes.
Under previous tax law, you could sell your home and defer any gains by purchasing a home of equal or higher value within a certain time period. Gains could continue to be deferred as you bought and sold homes. Under current tax law, when you sell your current home, you must recognize those deferred gains as well as the gain on your current home. If your total gain exceeds $500,000 for joint filers or $250,000 for single filers, you would owe capital gains tax on the excess.
- You did not live in the home for at least two of the preceding five years.
If you are forced to move due to employment changes, health reasons, or unforeseen circumstances, you can prorate the exclusion amount. For example, if a married couple owns and uses their principal residence for one year and then sells it because of a job change, they can exclude $250,000 of gain (one-half of the exclusion amount of $500,000). To qualify for prorating the exclusion, the Internal Revenue Service has indicated that unforeseen circumstances can include divorce, death, multiple births from the same pregnancy, becoming eligible for unemployment compensation, a change in employment status making you unable to pay household costs, damage to your home from a natural or manmade disaster or from an act of war or terrorism, and the condemnation or seizure of the property. There is a safe harbor rule that assumes a change in employment is the primary reason for your move if your new job is more than 50 miles farther from the home you sold than your prior job. The change in employment can apply to anyone who lives in the household.
- Your spouse dies and you sell the home after the year of his/her death.
Starting the year after your spouse's death, you must start filing as a single taxpayer. If you sell your home after that, you are limited to a $250,000 exclusion. However, if the home was jointly owned and you inherit your spouse's share, the basis of your spouse's share will be stepped up to market value at the date of his/her death.
- You married recently.
Even if you file a joint return, each party receives a $250,000 exclusion when both individuals own a home. If one spouse has a large gain on his/her house, however, the couple may want to live in the home for at least two years. Then, if the sale occurs more than two years after the sale of the first house, the couple will be eligible for the full $500,000 exclusion.
- You divorce.
If you sell your principal residence prior to becoming divorced, you will be eligible for the $500,000 exclusion. However, if only one spouse owns the home after the divorce, the exclusion will be reduced to a $250,000 limit. In the situation where both parties retain ownership but one party moves out, make the arrangement a condition of the divorce decree. Then, when the home is sold, the $500,000 exclusion will apply, even though one of the parties did not live in the home in two of the preceding five years.
- Part of your home is used for business.
You no longer have to allocate the gain between home and business use (including a home office or rental of a portion of your home) when selling your home, as long as the portion used for business is part of your main dwelling unit. Thus, all of your gain is eligible for exclusion. Previously, you had to allocate the gain between the home and business use portions, paying taxes on the gain attributable to the business use. If the business use portion is separate from your main dwelling unit, such as a converted detached garage, you must still allocate between business and home usage. In all cases, you still have to pay tax on the portion of the gain related to post-May 6, 1997 depreciation deductions. That gain is taxed as unrecaptured Section 1250 gain, subject to a maximum tax rate of 25%.