Unmarried individuals can exclude up to $250,000 in profits from capital gains tax when they sell their primary personal residence, thanks to a home sales exclusion provided for by the Internal Revenue Code (IRC). Married taxpayers can exclude up to $500,000 in gains.
This tax break is the Section 121 Exclusion, more commonly referred to as the "home sale exclusion."
How Does the Home Sale Exclusion Work?
Your capital gain—or loss—is the difference between the sales price and your basis in the property, which is what you paid for it plus certain qualifying costs. You would have a gain of $200,000 if you purchased your home for $150,000 and you were to sell it for $350,000. You wouldn't have to report any of that money as taxable income on your tax return if you're single, because $200,000 is less than the $250,000 exclusion.
Now let's say that you sold the property for $450,000. Your gain would be $300,000 in this case: $450,000 less your $150,000 basis. You would have to report a $50,000 capital gain on your tax return for the year, because $300,000 this is $50,000 more than the $250,000 exclusion.
Calculating Your Cost Basis and Capital Gain
The formula for calculating your gain involves subtracting your cost basis from your sales price. Start with what you paid for the home, then add the costs you incurred in the purchase, such as title fees, escrow fees, and real estate agent commissions.
Now add the costs of any major improvements you made, such as replacing the roof or furnace. Unfortunately, painting the family room doesn't count. The key word here is "major."
Subtract any accumulated depreciation you might have taken over the years, such as if you ever took a home office deduction. The resulting number is your cost basis.
Your capital gain would be the sales price of your home less your cost basis. You've suffered a loss if it's a negative number. Unfortunately, you can't claim a deduction for a loss from the sale of your main home, or for any other personal property. You've made a profit if the resulting number is positive. Subtract the amount of your exclusion, and the balance, if any, is your taxable gain.
The 2-out-of-5-Year Rule
Your property must be your primary residence, not an investment property, to qualify for the home sale exclusion. You must have lived in the home for a minimum of two out of the last five years immediately preceding the date of sale. The two years don't have to be consecutive, however, and you don't have to live there on the date of the sale.
You can live in the home for a year, rent it out for three years, then move back in for 12 months. The IRS figures that if you spent this much time under that roof, the home qualifies as your principal residence.
You can use this 2-out-of-5-year rule to exclude your profits each time you sell your main home, but this means that you can claim the exclusion only once every two years, because you must spend at least that much time in residence. You can't have excluded the gain on another home in the last two-year period.
Exceptions to the 2-out-of-5 Year Rule
You might be able to exclude at least a portion of your gain if you lived in your home less than 24 months, but you qualify for one of a handful of special circumstances.
You can calculate and claim a partial home sales exclusion based on the amount of time you actually lived in the residence if you qualify under one of the special rules.
Count the months you were in residence, then divide the number by 24. Multiply this ratio by $250,000, or by $500,000 if you're married, and you qualify for the double exclusion. The result is the amount of the gain you can exclude from your taxable income.
For example, you might have lived in your home for 12 months, then you had to sell it for a qualifying reason. You're not married. Twelve months divided by 24 months comes out to .50. Multiply this by your maximum exclusion of $250,000. The result: You can exclude up to $125,000, or 50% of your profit.
You would include only the amount of your gain over $125,000 as taxable income on your tax return if your gain was more than $125,000. For example, you would report and pay taxes on $25,000 if you realized a $150,000 gain. You could exclude the entire amount from your taxable income if your gain was equal to or less than $125,000.
Qualifying Lapses in Residency
You don't have to count temporary absences from your home as not living there. You're permitted to spend time away on vacation, or for business or educational reasons, assuming you still maintain the property as your residence, and you intend to return there.
And you might qualify for a partial exclusion if you're forced to move due to circumstances beyond your control. For example, you could exclude a part of your gain if your work location changed so you were forced to move before you'd lived in your house for the qualifying two years. This exception would apply if you started a new job, or if your current employer required you to move to a new location.
Document your condition and the situation with a statement from your physician if you're forced to sell your house for medical or health reasons. This, too, allows you to live in the home for less than two years yet still qualify for the exclusion. You don't have to file the letter with your tax return, but keep it with your personal records just in case the IRS wants confirmation.
You'll also want to document any unforeseen circumstances that might force you to sell your home before you've lived there for the required length of time. According to the IRS, an unforeseen circumstance is "an event that you could not reasonably have anticipated before buying and occupying your main home."
Natural disasters, a change in employment that left you unable to meet basic living expenses, death, divorce, and multiple births from the same pregnancy would all qualify as unforeseen circumstances under IRS rules.
Active duty service members aren't subject to the residency rule. They can waive the rule for up to 10 years if they're on qualified official extended duty—the government ordered them to reside in government housing for at least 90 days, or for a period of time without a specific ending date. They'll also qualify if they're posted at a duty station that's 50 miles or more from their home.
The Ownership Rule
You must also have owned the property for at least two of the last five years. You can own it at a time when you don't live there, or you can live there for a period of time without actually owning it.
Your two years of residency and the two years of ownership don't have to be concurrent.
For example, you might have rented your home and lived there for three years, then you purchased it from your landlord. Perhaps you moved out and rented it to a new tenant, then sold it two years later. You will have met both the ownership and the residency two-year rules, because you will have lived there for three years and owned it for two.
Service members can waive this rule as well for up to 10 years if they're on qualified official extended duty.
Married taxpayers must file joint returns to claim the exclusion, and must both meet the two-out-of-five-year residency rule. They need not have lived in the residence at the same time, however, and only one spouse must meet the ownership test.
The home sales exclusion isn't available to married taxpayers who elect to file separate tax returns.
A surviving spouse can use their deceased spouse's residency and ownership time as their own if one spouse dies during the ownership period, and the survivor hasn't remarried.
Your ex-spouse's ownership of the home and time living there can count as your own if you acquire the property in a divorce. You can add these months to your time of ownership, as well as to your time of residency, in order to meet the ownership and residency rules.
Reporting the Gain
Any profit from the sale of your home is reported on Schedule D as a capital gain if you realize a profit in excess of the exclusion amounts, or if you don't qualify for the exclusion. The gain is reported as a short-term capital gain if you owned your home for one year or less. It's reported as a long-term gain if you owned the property for more than one year.
Short-term gains are taxed at the same rate as your regular income, according to your tax bracket. The rates on long-term gains are more favorable: zero, 15%, or 20%, depending on your taxable income. The IRS indicates that most taxpayers pay no more than the 15% rate.
The 20% long-term capital gains rate doesn't apply unless your overall taxable income is $434,550 or more as of 2020, and you're single, or $488,850 if you're married and filing a joint return.
Keeping accurate records is key. Make sure your realtor knows that you qualify for the exclusion if you do, and provide proof if necessary. Otherwise, your realtor must issue you a Form 1099-S recording your profit and must send a copy to the IRS as well. This won't prevent you from claiming the exclusion, but it could complicate things, and you might need the help of a tax professional to straighten it out.
You must report the sale of your home on your tax return if you receive a Form 1099-S. Consult with a tax professional to make sure you don't take a tax hit that you don't have to take.
What About Foreclosure or a Short Sale?
It's unlikely that a gain would result from unfortunate circumstances that result in your lender foreclosing on your mortgage loan or agreeing to a short sale. But either of these events could result in taxable income to you if your lender also were to "forgive" or cancel any remaining balance of your mortgage after the property is sold.
Congress extended a tax code provision that allows you to exclude this type of profit from your taxable income as well. It was initially set to expire at the end of 2017, but it was extended through the end of 2020, affecting the tax return you'll file in 2021.