The IRS allows each individual taxpayer to exclude up to $250,000 of gain from the sale of their primary residence so long as certain ownership and occupancy requirements are met. If an individual/couple is unable to exclude all or part of the gain, it is taxable as a capital gain in the year of sale.
Unless they meet the reduced exclusion qualifications, taxpayers must prove that during the previous five-year period they owned the home for at least two years and, except for temporary absences, lived in the home as their main home for at least two years. Those two years do not have to be continuous; taxpayers must simply prove that they owned and lived in the property as their primary home for either 24 full months or 730 days during the five-year period ending on the date of sale.
A temporary absence would be for less than one year due to education, illness, vacation, business, or military service. The taxpayer would intend to return to the home and would continue to maintain the home.
If a taxpayer sells the land on which the home is located, but not the home itself, they are not allowed to exclude any gain from the sale of the land.
Home Acquired by Tax-Deferred Exchange
If a taxpayer acquires a home via a Sec 1031 tax-free exchange, they must own that home for a minimum of five years before excluding gain.
Taxpayers who meet the ownership and occupancy tests may exclude the entire gain on the sale of their primary residence up to $250,000, as long as gain has not been excluded on a sale of another home within two years of the sale of the current home. Couples may exclude up to $500,000 if all the following are true:
*The taxpayers are married and file a joint return for the year.
*Either the taxpayer or their spouse meets the ownership test.
*Both the taxpayer and their spouse meet the use test.
*During the two-year period ending on the date of the sale, neither the taxpayer nor their spouse excluded gain from the sale of another home.
More Than One Home
If a taxpayer has more than one home, they may exclude gain from the sale of their primary home only, even if the other home meets the two-out-of-five-year ownership and use test.
To qualify as a primary home, the property must be used by the taxpayer for the majority of the year. Other factors may include the taxpayer’s address listed on the taxpayer’s Federal and state tax returns, driver’s license, automobile registration and voter registration card; the taxpayer’s mailing address for bills and correspondence; place of employment; the location of the taxpayer’s banks; the principal place of abode of the taxpayer’s family members; and the location of religious organizations and recreational clubs with which the taxpayer is affiliated.
Ownership and Use Exceptions
In divorce situations, the terms of the divorce or separation document often allow one spouse to use the jointly-owned home for an extended period of time and then sell the home and split the proceeds with the former spouse. In this case the spouse who does not occupy the home will no longer meet the use test and would not be allowed to exclude the gain.
If the home was transferred to you by your current or former spouse and you are unable to pass the ownership test, you are considered to have owned it during any period of time when your current or former spouse owned it.
If your spouse died before the date of sale and you are unable to pass the ownership and use tests, you are considered to have owned and lived in the property as your main home during any period of time when your deceased spouse owned and lived in it as a primary home.
Physically or mentally disabled individuals who become unable to care for themselves are considered to have used their home during any period that they own the home and live in a licensed facility.
The individual must have owned and lived in his or her home for at least one year in order to qualify.
If you were able to defer gain from a prior home to your current home because it was destroyed or condemned, you may add the time you owned and lived in that home when determining the ownership and use tests for your current home.
Taxpayers who don’t qualify for a full exclusion can still exclude a partial amount even if they did not meet the ownership and use tests or if the exclusion was disallowed because of the once every two-year rule. In this case they must show that the home sale was due to a change in place of employment, health reasons, or qualifying unforeseen circumstances. The amount of reduced exclusion is determined on a case-by-case basis.
Credit Recapture – If you claimed a First-Time Homebuyer Credit and later ceased using it that home as your residence, you may be required to repay some or all of the credit.
Joint Owners Not Married – If you own a home jointly with owner(s) other than your spouse, each of you will need to apply these rules discussed to your individual ownership.
Separate Returns – If you and your spouse sell a jointly-owned home and file separate returns, both of you must determine your own gain or loss according to your ownership interest in the home.
Other Dispositions – Foreclosures, repossessions, and exchanges of your home are usually treated as sales.
Two-Year Period Between Sales
You are only allowed to exercise the exclusion once every two years unless they qualify for the reduced exclusion. Therefore, taxpayers may not exclude the gain on the sale of their home if during the two-year period (ending on the date of the sale) they sold another home at a gain and excluded all or part of that gain.