If you plan to sell your home at a profit, you probably assume there won’t be any taxes to pay on the transaction. In most cases, this is a pretty good assumption because of the $250,000 exclusion of gains on the sale of a principal residence — $500,000 for a married couple filing jointly. Even so, it’s important to understand home sale exclusion rules prior to a sale to determine whether or not you qualify.
The first step is to understand how to calculate the gain on your sale. The gain or loss is the difference between the selling price and your cost basis. The cost basis consists of two basic categories: the cost and expenses incurred at the time you purchased your home and those made for improvements that materially added to your home’s value or prolonged its life. Just making the expenditures isn’t enough. You must keep receipts, canceled checks or other proof.
The second step is to determine if a gain creates taxable income or qualifies for exclusion from income tax. For this we look to the Internal Revenue Service rules in code section 121 that state if a taxpayer has owned and used a residence as a principal residence for two years — the two years don’t have to be consecutive — or more out of a five-year period ending on the date of sale, the taxpayer may exclude up to $250,000 of gain for a single filer and $500,000 for a married couple. Furthermore, the taxpayer can’t have used the exclusion on another sale during the two years before the sale.
Congress is considering proposed tax reform legislation that changes the rules for home sale exclusion. The proposed measure would require taxpayers to own and use of a residence for five out of the previous eight years and allow taxpayers to only use the exclusion once every five years. In addition, the measure proposes limitations on the exclusion for high income individuals.
Taxpayers who don’t meet the existing two-year ownership and use tests or who have used the exclusion more than once in a two-year period, could qualify for a reduced exclusion. Reduced exclusions are only available, though, if the main reason the home was sold was due to either a change in place of employment, health issues or an event considered an unforeseen circumstance. For each of these exceptions there are specific safe harbor requirements to determine if they qualify and if so, how to compute the reduced gain exclusion.
When a home is used as a personal residence and also for business or to produce rental income, the tax treatment of any gain on the sale will depend on whether the business or rental portions of the property are within the same dwelling unit or not. For instance, if you have a home office inside your house, it’s not necessary to allocate gain on the sale of the property between the part of the property used for the business and the part used as a home. However, the exclusion doesn’t apply to any depreciation allowed or allowable for periods after May 6, 1997. Gains attributable to depreciation deductions are subject to recapture as income.
Conversely, if your home office is in a separate structure — a free-standing garage or guest house, for example — you would be treated as having sold two separate properties for purposes of using the home sale gain exclusion: a personal residence and business building. The gain you realize on the sale of your home would be entitled to the exclusion. But any profit you realize on the sale of the business part of your property would be taxed.
If the home had a period of nonqualified use, the gain attributable to the period of nonqualified use may be taxable. Nonqualified use is considered any time after 2008 a taxpayer or spouse doesn’t use the home as a principal residence. This can occur when converting a vacation or rental property to a personal residence. There are some exceptions to these rules, including temporary absences due to employment, health or other unforeseen circumstances.
On the other hand, converting a principal residence to a rental or a vacation home won’t create a period of nonqualified use. That’s because periods after the last time the home was used as a principal residence aren’t counted. However, the exclusion will only be available if the taxpayer has used the home two out of five years before sale. Waiting too long to sell after conversion to a rental can prevent a taxpayer from excluding the gain. In addition, any depreciation claimed after May 6, 1997 must be recaptured as income.
As you can see, the rules can get complicated. It might be wise to seek the advice of a professional. With a bit of guidance and planning before a sale, you have a better chance of reducing income taxes.