Taxation on the Sale of Your Home – Part 1

Jane Young, CFP, EA

In most situations, if you sell your personal residence that you have lived in for 2 of the last 5 years, you will qualify for an IRC Section 121 Exclusion.   Section 121 excludes gains of up to $250,000 for an individual and $500,000 for a married couple filing jointly.  You must own your home and use it as your primary residence.  Married taxpayers may exclude up to $500,000 if either spouse owned the home for 2 of the last 5 years and both spouses lived in the home for 2 of the last 5 years.   If eligible, you can use this exclusion once every two years.  Any gains in excess of the exclusion will be taxed at capital gains rates.  If your gain does not exceed the exclusion you don’t need to report the sale on your tax return.

If you own more than one home, you are only eligible for the exclusion on your primary residence.  Additionally, you are not eligible for the section 121 exclusion if you acquired your home through a like kind exchange (1031 exchange) in the last 5 years or if you claimed an exclusion over the past 2 years.  If you don’t meet the requirements because you lived in your home for less than two years and the reason for the sale is due to poor health, change of employment, death, divorce, or other unforeseen circumstances, you may be eligible for a partial exclusion.  Additionally, special rules apply to qualifying members of the Uniformed Services or the Foreign Service and employees of the intelligence community and the Peace Corps.  The exclusion of gains does not apply to gains attributable to depreciation claimed for rental or business use after May 6, 1997.
If you lived in your home for 2 of the last 5 years but failed to use the home as your primary residence at any time after January 1, 2009, some of your gain may be ineligible for exclusion.   The time during which your home was used as a rental or vacation home is considered non-qualified use.  Any gain on your home during this timeframe is not eligible for exclusion and will be taxed at capital gains rates.  This does not reduce the actual amount of your exclusion and if your gain is large enough you may be able to use your full exclusion.

To calculate the gains attributable to non-qualified use, divide the number of years of non-qualified use (years home not used as primary residence after 2008) by the total number of years the home has been owned.  For example if you rented your home for 4 years and owned your home for 20 years, gains attributed to non-qualified use are equal to 4/20ths or 20%.  Therefore, 20% of the gain will be taxable (plus any depreciation recapture) and 80% may qualify for exclusion.

Depreciation will be addressed in Part 2 of this article.