One of the most well-worn clichés in human language is there’s nothing certain except death and taxes. Generally, that’s true – but not always when it comes to real estate. That’s because one of the most generous provisions in the income tax code is the home sale tax exclusion. It enables homeowners to shield a substantial gain on the sale of their primary residence from income tax.
The Benefits of the Home Sale Tax Exclusion
Under the IRS income tax code, you are required to report the gain on the sale of most assets, including financial securities and real estate. Such a gain will be taxable as capital gains.
If the assets are owned for longer than one year, they are considered to be long-term capital gains. They will then be subject to capital gains taxes, which are generally lower than ordinary income tax rates.
However, the home sale tax exclusion allows a couple who are married filing jointly to exempt up to $500,000 of the gain on sale of their primary residence. That means you can quite literally sell your primary residence at a profit, and pay zero income tax on up to $500,000 of the profit.
And remember, that’s not the gross sale price of the property, but the net gain on the sale over the acquisition cost, plus improvements on the home, and any transaction costs involved in either the purchase or sale of the property.
It works something like this. You and your spouse purchase a house and occupy it as your primary residence. The purchase price is $1 million. Ten years later, you sell the property for $1.5 million. That results in a capital gain of $500,000.
Due to the home sale tax exclusion, none of the $500,000 gain is taxable!
In theory, you can use the first $1 million from the sale of the property to purchase your next home (assuming there was no mortgage on the property), and then use the $500,000 gain for any other unrelated purpose you choose, and there will still be no income tax liability.
The exclusion can be used multiple times over your lifetime, as long as you meet the requirements.
The Two Year Rule and How it Works
To take it vantage of the home sale tax exclusion, you must occupy the property as your primary residence for a minimum of two years prior to the sale. The exclusion isn’t limited to a house either. A condominium or a cooperative can qualify, as well as a mobile home if it is fixed to the land.
The occupancy doesn’t need to be recent either. The rule holds that you must occupy the property for at least two years out of the past five. That means that you can live in the home for two years, rent it out for the last three years, and still qualify the gain for the exclusion.
In an interesting twist, if you purchase the property as a rent-to-own, the time that you spent living in the house as a tenant also counts toward the two-year occupancy requirement.
Home Sale Exclusion Requirements
In order to take the full exclusion of $500,000, your tax status must be married filing jointly for the year in which the sale of the property takes place. Also, both you and your spouse need occupy the property as your primary residence for at least two years.
However, only one spouse is required to meet the ownership requirement. That is, the gain on the sale of the property can still qualify for the tax exclusion if only one spouse owns the property. But again, the non-owning spouse must meet the two-year occupancy requirement.
And no matter what, the exclusion cannot be taken more than once every two years.
Even if you and your spouse don’t meet all of the requirements, you may still be able to take the exclusion. However, the exclusion will be calculated as though you are not married to one another. This means that each of you can qualify for the exclusion of up to $250,000.
And if you are not married, but both own the property, each of you can qualify for the exclusion separately, up to $250,000 each.
You can qualify for the full $500,000 however even if your spouse dies. But you will have to claim the exclusion within two years of your spouse’s death.
Unusual Ways the Exclusion Can Work to Your Advantage
The home sale exclusion applies only to your principal residence. And you can only count one residence as a principal at a time. But let’s say that you have a second home, which normally would not qualify for the exclusion. If you want to sell the property, and there was a substantial gain on the sale, you can exclude up to $500,000 of the gain if you move into the property and make your primary residence for at least two years.
And as noted earlier, there’s no limit on the number of times you can claim the exclusion. You simply have to be sure that you don’t do it more than once every two years.
The exclusion is also a perfect retirement strategy. If you live in your home for many years, and the value rises substantially, the $500,000 exclusion will make the gain equivalent to a Roth IRA. $500,000 of accumulated value will available to be taken and used tax-free for the rest of your life. Not a bad deal just for living in the property!
The Exclusion is Also Available for Single Tax Filers
Though we’ve been discussing the home sale exclusion regarding married couples filing jointly, it is also available to single homeowners as well.
All of the same requirements apply, including the two-year minimum rule that applies to both ownership and occupancy of the property, as well as the fact that it must be a principal residence.
The exclusion is reduced to $250,000 for single homeowners. But that still shelters a substantial gain from taxes. Also, it can be repeated every two years.
So live in your home, and enjoy it. And when you are ready to sell it and take a profit, you can do so without having to worry about paying taxes on a very large part of the gain.