Individuals can exclude up to $250,000 of income from capital gains tax on the sale of their primary residence, thanks to the Internal Revenue Code (IRC) exclusion of home sales. Married taxpayers can exclude up to $500,000 gains.
This tax exemption is the section 121 exclusion, more commonly known as the "home sale exclusion."
How does the Home sale exclusion work?
Your capital gain (or loss) is the difference between the sale price and your ownership basis, which is what you paid for it plus some eligible costs. For example, you would earn $230,000 if you bought your house for $150,000 and sold it for $380,000. You are not required to report this money as taxable income on your tax return if you are single because $230,000 is less than the exclusion of $250,000.
Now suppose you sold the property for $480,000. Your profit would be $330,000 in this case: $480,000 minus your basis of $150,000. You have to report a capital gain of $80,000 on your tax return for that year because $330,000 is $80,000 more than the exclusion of $250,000.
Calculating Your Cost Basis and Capital Gains
The formula for calculating your gain is to deduct the basis price from the selling price. Start with what you paid for the house, then add any costs you incurred for the purchase, such as bond fees, warranty fees, and real estate brokerage fees.
Now add the costs of any major upgrades you made, such as replacing the roof or installing a new oven. Unfortunately, painting the family room does not count. The keyword here is "major."
Subtract any accumulated depreciation that you may have had over the years, just as you would have already taken a deduction from your home office. The resulting number is your cost basis.
Your capital gain would be the selling price of your home, less the basis price. You have suffered a loss if it is a negative number. Unfortunately, you cannot claim a loss allowance for the sale of your principal residence or any other personal property. You have made a profit if the resulting number is positive. Subtract the amount of your exclusion, and the balance, if any, is your taxable income.
2-out-of-5-year rule
Your property must be your main residence and not a real estate investment in order to benefit from an exclusion from the sale of the home. In addition, you must have lived in the house for at least two of the past five years immediately prior to the date of the sale. However, the two years must not be consecutive, and you must not reside there on the date of the sale.
You can live in the house for a year, rent it out for three years, and then move in again for 12 months. The IRS calculates that the house is considered your primary residence if you have spent that much time in the house.
You can use this 2-5 year rule to exclude your income every time you sell your primary residence, but that means you can only claim the exclusion once every two years because you have to spend at least that time in your residence.
Exceptions to this rule
You might be able to exclude at least some of your income if you've lived in your home for less than 24 months, but you qualify under one of the few special circumstances.
You can calculate and claim a partial exclusion from the sale of the house based on how much you actually lived in the house if you qualify under any of the special rules.
Count the months spent in the home, then divide the number by 24. Finally, multiply this ratio by $250,000 or $500,000 if you are married and will qualify for the double exclusion. The result is the amount of gain that you can exclude from your taxable income.
For example, maybe you lived in your house for 12 months and then had to sell it for a valid reason. You're not married? Twelve months divided by 24 months is 0.50. Multiply that by your maximum exclusion of $250,000. The result: You can exclude up to $125,000 or 50% of your gains.
You would only include the amount of your income over $125,000 as taxable income on your tax return if your income was over $125,000. For example, you would declare and pay taxes of $25,000 if you made a profit of $150,000. You can exclude the total amount of your taxable income if your income is equal to or less than $125,000
Qualifying Lapses in Residency
You do not have to count temporary absences from your home as if you did not live there. You are allowed to go on vacation or for the purpose of work or study, as long as you still retain the property as your residence and intend to return there.
And you may be eligible for a partial exclusion if you are forced to move due to circumstances beyond your control. For example, you can exclude part of your income if you change jobs and are forced to move before living in your home for the two-year qualification. This exception applies if you are starting a new job or if your current employer asks you to move.
Document your condition and situation with a statement from your doctor if you are forced to sell your home for medical or health reason(s) that allows you not to live at home for less than two years and continue to benefit from the exclusion. You don't need to send the letter with your tax return, but keep it with your personal documents if the IRS asks for confirmation.
You should also document any unforeseen circumstances that might require you to sell your home before you live there long enough. According to the IRS, an unforeseen circumstance is "an event that you could not have foreseen before buying and occupying your main home."
Natural disasters, a change of job that made you unable to pay your basic living expenses, death, divorce, and multiple births from the same pregnancy would be considered unforeseen circumstances under the IRS rules.
Active duty service members are not subject to the residency rule. However, they can waive the rule for up to 10 years if they occupy a qualified official extended duty – the government ordered them to live in public housing for at least 90 days or for a period without a specific end date. They will also be eligible if they are posted at a gas station 50 miles or more from their home.
Ownership rule
You must also have owned the property for at least two of the past five years. After that, you can own it when you don't live there, or you can live for a while without actually owning it.
The two years of residence and the two years of ownership must not be simultaneous.
For example, maybe you rented your house and lived in it for three years, then purchased it from the owner. Maybe you moved in and rented to a new tenant, then sold two years later. You will be subject to the rules of ownership and residence for two years, as you have lived there for three years and have owned a house for two years.
Service members may also waive this rule for up to 10 years if they occupy a qualified extended duty.
Married taxpayers
Married taxpayers must file joint returns to request exclusion, and both must meet the two out of five years residency rule. However, they must not have lived in the residency at the same time, and only one of the spouses must meet the property test.
The home sales exclusion is not available to married taxpayers who choose to file separate income tax returns.
The surviving spouse can use their deceased spouse's residency and ownership time as their own if one of the spouses dies during the marriage and the survivor has not remarried.
Divorced taxpayers
The ownership of your ex-spouse's house and how long you lived there can be yours if you acquire the property through a divorce. You can add these months to your time of ownership and residence in order to comply with the ownership and residence rules.
Reporting the gain
Any income from the sale of your home is reported on Schedule D as a capital gain if you make a profit that exceeds the exclusion amounts or if you are not eligible for exclusion. The gain is reported as a short-term capital gain if you have owned your home for one year or less. It is declared as a long-term gain if you have owned the property for more than a year.
Short-term income is taxed at the same rate as your regular income, depending on your tax group. Long-term gains are more favorable: 0%, 15%, or 20%, depending on the tax basis. The IRS says most taxpayers don't pay more than 15%.
The 20% long-term capital gains tax only applies if your total taxable income was $434,550 or more in 2020 and you are single or $488,850 if you are married filing jointly.
If you receive a Form 1099-S, you must report the sale of the house on your tax return. Check with a tax professional such as ELLIOT KRAVITZ, ATP. if you are unsure of what to do.
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