When is the Sale of My Personal Residence Taxable?
When it comes to real estate transactions involving the sale of a personal residence, many homeowners, including members of the uniformed services, foreign service, and intelligence agencies, are concerned about the potential tax implications, especially when it comes to maximizing the tax benefits of selling their home. The good news is that in most cases, you can exclude all or part of any gain from taxation if you meet certain criteria, such as transferring your home as part of a divorce settlement.
In this article, we will discuss the capital gains tax exclusion rules for married couples filing jointly and other scenarios related to selling a principal residence. We will also provide additional information about ownership and use tests as well as how to report your home sale on your taxes to reduce the tax bill. By understanding these rules and regulations, you can maximize your profits when it comes time to sell your home. If it’s a reportable sale, you’ll file Schedule D and Form 8949 with your Form 1040.
Exploring the Basics
Understanding the taxability of the sale of your personal residence requires familiarity with certain key concepts. Let’s explore them one by one:
Determining Primary Residence
Before delving into tax implications, it’s important to establish your primary residence and satisfy the use requirement. The Internal Revenue Service (IRS) considers a property your primary residence if you live in it for the majority of the year and physically occupy the home. This definition is crucial because tax rules differ for primary residences compared to second homes or investment properties. Personal property, such as a houseboat, house trailer, or stock held by a tenant-stockholder in a cooperative housing corporation, that is not a fixture under local law will not qualify as a residence. Improvements to your primary residence can add value to your home and prolong its useful life. It is important to note that the cost of these additions and improvements can be added to the basis of your property.
Determining your primary residence is relatively straightforward if you live in one home for the majority of the year. However, if you split your time between multiple properties, factors such as the amount of time spent in each home, the location of your personal and professional activities, and the address used for various legal and financial purposes can help determine which property qualifies as your primary residence. And, your house doesn’t have to be a single-family home—a condominium, a cooperative apartment, a mobile home, or a houseboat could all qualify as your main home.
Capital Gains Tax
When you sell a personal residence, the potential tax liability arises from capital gains. Capital gains tax applies to the profit earned from selling an asset, in this case, your home. It’s calculated by subtracting the property’s cost basis (the purchase price plus eligible expenses) from the sale price.
The cost basis of your home includes not only the purchase price but also certain expenses associated with buying and improving the property. These expenses can include real estate agent fees, closing costs, and the costs of any significant renovations or additions that increase the value of the property.
It’s important to keep track of these costs throughout your ownership of the property to accurately calculate your capital gains tax when you sell. By understanding the concept of cost basis and accurately documenting eligible expenses, you can minimize your tax liability.
Exclusion of Gain
The good news for home sellers is that the IRS allows for an exclusion of gain on the sale of your home, subject to certain criteria. As of 2023, if you meet the ownership and use tests, you may be eligible to exclude up to $250,000 in capital gains if you’re a single taxpayer or up to $500,000 if you’re married and filing jointly. This exclusion can significantly reduce or eliminate your tax liability. Some taxpayers believe that any profit on the sale of a home is taxable—but that’s not true. There is an exclusion on capital gains up to $250,000, or $500,000 for married taxpayers, on the gain from the sale of your main home.
That exclusion is available to all qualifying taxpayers—no matter your age—who have owned and lived in their home for two of the five years before the sale. Additionally, it’s important to consider your tax bracket when calculating your capital gains tax. For example, if your combined income places you in the 20% tax bracket, you would owe $40,000 in capital gains tax on an amount of the gain of $200,000 from the sale of your home. The capital gains tax on your home sale depends on how much profit you make from the sale of your home. Profit is generally defined as the difference between how much you paid for the home and how much you sold it for.
Qualify with ownership test
To qualify for the exclusion, you must meet both the ownership test and the use test. The ownership test requires you to have owned the rental property or ownership of a home for at least two years during the five-year period leading up to the sale. The use test requires you to have lived in the property as your primary residence for at least two years during the same five-year period. These tests are generally applied on a pro-rata basis, meaning you don’t need to have used the rental property as your primary residence continuously for two years but rather cumulatively over the five-year period.
If you become physically or mentally unable to care for yourself, and you use the residence as your principal residence for at least 12 months of the 5 years before the sale or exchange, any time you spent living in a care facility, like a nursing home, counts toward your residence requirement. Members of the uniformed services, foreign service, and the intelligence community of the United States can choose to have the five-year-test period for ownership and use suspended for up to ten years during any period you or your spouse serve on “qualified official extended duty” as a member of the uniformed services, Foreign Service, or the federal intelligence agencies. You are on qualified extended duty when, for more than 90 days or for an indefinite period, you are at a duty station at least 50 miles from your main home or residing under orders in government housing.
Please be aware that the exclusion for gain can only be used once every two years. If you sell another primary residence during this time frame, you may not be eligible for the exclusion and may have to pay capital gains tax.
Sale of Principal Residence: Capital Gains Tax Exclusion
If you are married and filing a joint tax return, then you may be eligible for an unlimited amount of capital gains exclusion on the sale of your principal residence, including the sale of the home. To qualify, both spouses, including former spouses, must have met the eligibility requirements of owning and using the home as their main residence during two out of the last five years before the date of sale. You must meet all other conditions to be eligible for the exclusion, such as having owned the home for at least two of the five years prior to its sale.
Exclude The profit
The exclusion rule generally allows a taxpayer to exclude from gross income gain realized from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer’s principal residence for a period totaling 2 or more years. A taxpayer who disposes of more than one residence within two years or who otherwise fails to satisfy the requirements, for example due to a job change or health problem, may qualify for a reduced exclusion amount. The IRS has issued guidance to clarify the rules, including the exclusion requirements for taxpayers who file a joint return.
If you meet certain requirements, you can avoid paying taxes on up to $250,000 of capital gain from selling your personal residence.
- Ownership and use. To qualify for the sale, the person must have used the home as their main residence for at least two years within the past five years. These two years don’t have to be in a row.
- Frequency limitation. The exclusion applies to a maximum of one sale per two-year period.
Note the following:
(1) If you didn’t use your property as your main home after 2008, you can’t exclude any gain from its sale which is attributable to that period.
(2) If you are unmarried and jointly own a main home, you can each exclude up to $250,000 of gain if you meet the requirements stated in IRC Section 121.
Married Couple – Each Spouse Sells a Principal Residence
If both spouses meet the ownership, use, and frequency tests and own separate principal residences, each of them can exclude up to $250,000 of a capital gain on the sale of their own home. For instance, if they sell their homes and make a profit, they can each exclude up to $250,000 of that profit from their taxable income. Additionally, if the spouses meet all of the conditions, they may be able to increase their exclusion amount from $250,000 to $500,000. This is referred to as the maximum exclusion.
Example 3: Dan and Delores got married on May 1, 2021, and purchased a new home. Earlier in 2021, both Dan and Delores sold their respective principal residences, where they had lived for more than two out of the last five years. Neither of them had excluded a principal residence capital gain in the previous two years. Dan had a capital gain of $210,000, while Delores had a capital gain of $430,000. Their total capital gains amount to $640,000. They can exclude a total of $460,000 ($210,000 for Dan and $250,000 for Delores). However, Dan cannot exclude any portion of Delores’ excess capital gain of $180,000.
Surviving Spouse Sells a Principal Residence
If an individual’s spouse has passed away within the past two years, the individual can still be eligible for the $500,000 capital gain exclusion as an unmarried surviving spouse.
- To qualify, either the deceased spouse or the surviving spouse must have owned the principal residence for at least two years prior to the death of the spouse.
- Both spouses need to meet the two-year usage requirement right before one of the spouses passes away.
- If the surviving spouse gets married again before selling or exchanging the residence within two years, they are not required to follow the rule that neither spouse should have used the exclusion in the past two years.
Conclusion
The capital gains exclusion on the sale of personal residence is an important tax advantage for married couples filing jointly or individuals who are surviving spouses. As long as you meet all the requirements set forth by the IRS, you can exclude up to $250,000 (or up to $500,000 for qualifying surviving spouses) from your taxable income when selling your home. It is important to understand all the rules and regulations related to the sale of your principal residence and take advantage of this tax benefit whenever possible. You should consult a qualified tax professional for assistance with understanding the full scope of taxation when it comes to selling your principal residence.
FAQs
What are the tax implications of selling my personal residence?
The tax implications of selling your personal residence may vary depending on various factors, such as the length of time you’ve owned the property and whether it qualifies for certain exemptions. It’s best to consult with a tax professional or accountant to understand the specific implications of your sale.
How long do I need to live in my home before I can sell it and avoid capital gains taxes?
To qualify for the capital gains tax exclusion on the sale of your personal residence, you must have lived in the home for at least two of the past five years before selling. This requirement applies to both single individuals and married couples filing jointly.
Do I need to report the sale of my personal residence on my tax return?
Yes, you may need to report the sale of your personal residence on your tax return. The IRS requires you to report any capital gains from the sale of a personal residence, although there are certain exemptions and exclusions that may apply. It is best to consult with a tax professional for specific guidance.
What happens tax-wise when you sell your house?
When you sell your personal residence, you may be eligible for certain tax benefits. If you’ve owned and lived in the home for at least two of the past five years, you can exclude up to $250,000 of the profit from capital gains taxes if you’re single, or up to $500,000 if you’re married and filing jointly.
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