According to the CPA Journal, Home sellers can exclude (not defer) up to $250,000 of housing profits from capital gains tax; married couples who file a joint tax return can exclude up to $500,000 of housing gains. In the case of a married couple, either or both spouses can own the property, and the same individual or couple can claim these exclusions repeatedly, not just once in a lifetime.
Several conditions must be met in order to earn the $250,000 or $500,000 tax exclusion. The exclusions apply only to sales of a primary residence, that is, the main home where the seller has lived. Selling a vacation home or investment property does not qualify. A primary residence can be any dwelling, however, including a condo, a co-op, a mobile home, a recreational vehicle, or even a boat. As long as it has sleeping, cooking, and toilet facilities, the place where the seller has spent the most time can qualify for these exclusions on a profitable sale.
The seller must have owned the home and used it as a primary residence for at least two of the five years before the sale. The two years can be interrupted. Suppose, for example, that Arlene bought a house for $300,000 in May 2013. Arlene then lived there until June 2014, when she relocated to another state. In December 2016, Arlene moved back into the house. In July 2018, Arlene sold the house for $400,000; she had owned the house since May 2013, so she met the two-year ownership requirement. During the five-year period prior to the sale, Arlene used the house as her primary residence for 14 months (May 2013 to June 2014) and then for 20 months (December 2016 to July 2018). Therefore, she passed the two-year (24-month) residency requirement as well. Arlene can exclude her $100,000 gain from tax because it is less than the $250,000 maximum exclusion. If her gain had been $280,000, she could take the full $250,000 exclusion and would owe tax on the $30,000 excess gain (probably a 15% or 20% tax on long-term capital gains and perhaps a 3.8% surtax on net investment income).
Home sellers can claim the $250,000 or $500,000 tax exclusion multiple times, with no limit on how often they use the tax benefit; however, these exclusions usually cannot be claimed within two years. In the previous example, Arlene claimed an exclusion for a house sale on July 31, 2018. Therefore, if she sells another house before July 31, 2020, she probably cannot claim any tax exclusion on that sale.
Some exceptions do apply in cases of poor health, job changes, or unforeseen circumstances. A sale due to poor health after 12 months of ownership and occupancy, for example, could qualify for a $125,000 or a $250,000 tax exclusion (50% of the maximum amounts) because the sale occurred halfway through the required two years. Such exclusion amounts might cover all or most of the gain in a short time period.
Impact of Business Use
Selling a house that was used as a rental property as well as a main home adds complexity to the capital gain exclusion rules. Various possible scenarios exist on such partial business use of a primary residence, with myriad tax treatments depending on when the business versus personal use has occurred. Generally, a home seller must reduce the basis of the property by the amount of depreciation allowed before determining any gain on the sale. Gain attributable to depreciation may be subject to the 25% unrecaptured Internal Revenue Code (IRC) section 1250 gain tax rate and possibly to the 3.8% net investment income surtax.
To continue the above example, suppose that when Arlene moved out of her house from June 2014 to December 2016, she rented it to a tenant. Arlene cannot exclude the part of the gain on the 2018 sale equal to the depreciation she claimed or was allowed to claim while her house was a rental property. She also must calculate the amount of her gain attributable to the period of non-qualified (rental) use, as described below, which may reduce her tax exclusion.
Selling a Vacation Home
As mentioned, the $250,000/$500,000 capital gain exclusions apply to sales of a primary residence. Profitable sales of vacation homes are fully taxed.
One possible way around this limitation is to sell a primary residence and use the exclusion, then move into a vacation home full time. After two years, the former vacation home will qualify as a primary residence and another exclusion. The tax savings on such a transaction, however, have been reduced by the Housing and Economic Recovery Act of 2008. Vacation homes (and rental properties) that are converted to primary residences and then sold must allocate ownership time between “qualified” and “nonqualified” use after 2008.
For example, Charles and Diana have a beach house they have owned since 2003 where their family spends a great deal of time in the summer. In December 2016, they sell their long-term primary residence and report a $400,000 gain on the sale, fully covered by the $500,000 gain exclusion for couples filing jointly. Immediately after the sale, they move into the beach house and live there full time. They can wait for two years and then sell their beach house, using the capital gain tax exclusion once more, but the amount excluded is dictated by the 2008 legislation. They had eight years (2009 through 2016) of non-qualified use of their beach house when it was a vacation home. Assuming a purchase date of January 1, 2003, and a sale date of December 31, 2018, they will have owned the beach house for 16 years. Half of that time was nonqualified, so half of the gain on the sale would be taxed and half (up to $500,000) would be excluded.
As explained above, home sellers generally qualify for a capital gain tax exclusion of up to $250,000/$500,000 on the sale of a home owned and occupied for more than two years. That exclusion often results a tax-free sale. Some homes, though, sell for apparent profits that exceed those amounts. It is still possible to reduce or even eliminate tax on such sales by proving a substantial basis in the property. For example, Fred sells his home of many years for $600,000, qualifying for the $250,000 exclusion. If Fred’s basis in the home is $220,000, Fred will have a $380,000 gain. After using the $250,000 exclusion, he will only owe tax on the balance, $130,000. If Fred’s basis is $410,000, however, he will have a gain of only $190,000 on a $600,000 sale, and the tax exclusion would make the sale tax free. Therefore, increasing the basis of a primary residence can generate tax savings. It is impossible to know when a house will be sold or for how much, so homeowners should track basis carefully from the first day of ownership.
Initially, a home’s basis is the purchase price. Some of the costs associated with the purchase can be added to the basis, including legal fees for the title search, survey fees, and transfer taxes. All records of the home purchase, such as the closing statement, should therefore be retained indefinitely. The cost of home improvements can be added to the home’s basis. Such improvements are changes that increase the home’s value, prolong its useful life, or adapt it to new uses. Numerous projects qualify, from building a deck to installing a fence to putting in storm windows; however, routine painting, repairs, or maintenance will not boost a home’s basis.
The sidebar, Home Improvements that Increase Basis, provides some examples of improvements that increase basis in a residence. The IRS notes that home sellers can include repair-type work done as part of an extensive remodeling or restoration job. For example, replacing broken windowpanes is a repair, but replacing the same window as part of larger project is an improvement.
A home seller who can exclude all of the resulting gain from tax does not have to report the sale on a federal income tax return. Any gain that cannot be excluded, however, must be reported on Schedule D (Capital Gains and Losses) of IRS Form 1040. Any loss on a sale of a residence will not generate a capital loss that can be claimed on a tax return. For details on how to report gain or loss, see the Instructions for Schedule D and the Instructions for IRS Form 8949.