Locking in a Partial Home–sale Exclusion

Despite the recent nationwide real estate slump, you may realize a significant gain if you sell your home, particularly if you bought the place before prices soared in prior years. What about the tax consequences? Generally, the amount of the proceeds is subject to tax at capital gain rates. Currently, the maximum tax rate on net long-term capital gain is 15%, but rates are scheduled to increase in future years.

Fortunately, you may be able to take advantage of a big break in the tax law. If you have owned and used the home as your principal residence for at least two of the five years prior to the sale, you can exclude the tax on the first $250,000 of gain. The home–sale exclusion is doubled to $500,000 for joint filers.

This tax break does not apply if you sold another qualified principal residence within the last two years. Technically, it is possible to qualify for a home–sale exclusion every two years.

The maximum $500,000 exclusion for joint filers may be applied if either spouse meets the two-year ownership test, each spouse meets the two-year use test or neither spouse has elected the exclusion within the last two years. These rules might be especially important if you are getting married or have recently divorced. Note: Recent tax law developments provide more flexibility to divorcing couples.

What happens if you are forced to sell the home before you have met the two-year requirement? In this case, you may qualify for a partial exclusion if the sale is made due to a change in employment, health reasons or some other unforeseen circumstance. Under each of these safe-harbor methods, the maximum exclusion is prorated, based on the time spent in the home.

Furthermore, the IRS has been relatively lenient in applying the safe-harbor rules. For instance, it may approve a partial exclusion due to one of the following:

  • An involuntary conversion of the residence.
  • Natural or man-made disasters, acts of war and acts of terrorism that result in a casualty to the residence.
  • Death, divorce or legal separation of a qualified individual.
  • Loss of employment where a qualified individual is eligible for unemployment compensation or if change in employment status renders the individual unable to pay housing costs and reasonable basic living expenses.
  • Multiple births resulting from the same pregnancy.

Other factors in a home sale may cause tax implications. For instance, if you have used a room in the home as a business office, you may have to “recapture” some of the tax benefit of depreciation deductions claimed in the past. Make sure you have all the tax information you need to make decisions relating to a home sale.