Taxes When Selling a House

Capital Gains Exclusion for Primary Residences

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Thanks to the Taxpayer Relief Act of 1997, you probably won't take a big capital gains tax hit if you sell your primary residence. Taxpayers can exclude up to $250,000 in capital gains when they sell their homes, and up to $500,000 if you’re married and filing a joint return. This special tax treatment is known as the Section 121 exclusion.

How Does the Section 121 Exclusion Work?

Here's an example.

Brian in Louisiana has owned and lived in his house for three years. He plans to sell the house for $150,000, and he bought the house for about $105,000. Brian asked, "What kind of taxes do I have to pay when selling? I know have to pay realtor fees, but what, if any, other taxes are applicable?"

Of course, there may be transfer, stamp or property taxes due when you're selling a house, and those taxes are listed in detail on the settlement statement prepared by the title company during escrow. But Brian should not have to pay any federal income taxes on the sale because of his gain— the difference between the purchase price or his tax basis and the sale proceeds— is $45,000, significantly less than the $250,000 exclusion.

Brian also meets another tricky requirement. The Internal Revenue Service says the homeowner must have owned and lived in the property as his main residence for two of the past five years.

Brian lived in his home for three years, so his capital gain of approximately $45,000 would be completely tax-free.

And here’s some more good news: The Section 121 exclusion isn’t a one-shot deal. You can effectively sell your residence every two years without owing any capital gains tax on the proceeds.

You don’t even have to report the sale of your home on your tax return if your gains don’t exceed $250,000 or $500,000 if you’re married.

Partial Exclusions

Taxpayers who sell their principal residences before meeting the two-out-of-five-year rule might still qualify for a partial exclusion of their gains. The tax code allows taxpayers to exclude a portion of their capital gains if they must sell to relocate for work, because of health issues, or due to other unforeseen circumstances.

If your employer transfers you to a position on the other coast after you’ve lived in your home for one year, the sale of your home is work-related and not something you voluntarily elected to do. You won’t have to take a big tax hit, but you can’t use the entire $250,000 exclusion. If you were in residence for one year, you lived in your home for 50 percent of the required time. Multiply 50 percent by $250,000, and the result is that you can exclude a profit of up to $125,000. You would only pay capital gains on any proceeds exceeding this amount. 

Members of the military are completely exempt from the two-year rule for up to 10 years if they’re required to move due to service commitments.

So go ahead and sell your house without worrying about Uncle Sam.

Unless you realize pretty significant profits or you’ve only lived there for a very short time, you can most likely do so tax-free. 

NOTE: Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and is not a substitute for tax advice.