Buying a home is one of the biggest investments that most people will make in their lifetime. And selling a home may be the biggest potential “windfall” that a person will see in their lifetime. Many people will probably call their accountant, in a sort of panic and ask the question “I sold my primary home, is it taxable?”. For the most part the answer is no. Thanks to the home sale exclusion that was introduced with The Revenue Act of 1964. This exclusion is known as the capital gain exclusion.
What is the Home Sale Capital Gain Exclusion?
Like I stated above the capital gain exclusion refers to The Revenue Act of 1964. In this bill it was decided that it would be a good idea to allow homeowners to exclude the sale of a primary home. This is a good idea because saddling people with a huge tax bill wouldn’t motivate people to buy homes. Over the years, the structure, implantation, and the rules itself has changed. In the most current form, the exclusion (called a Section 121 exclusion) has a use test and an ownership test that the homeowner must meet.
According to the Internal Revenue Service in Topic 701 “Sale of your home”, “You’re eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods.” However, the catch is you must meet both of the test within 5 years of the sale of the home. If you meet both the ownership and use tests, then you should be allowed to exclude up to $250,000 of capital gains from a home sale if you’re a single file and $500,000 if you are married filing jointly.
What if I don’t meet the eligibility test for a home sale exclusion?
This is a common situation. Our lives are complicated and sometimes chaotic, things are constantly shifting and changing. In most cases, failing to meet the ownership or use test will result in all of the gain from the house sale being taxable. However, there is a partial gain exclusion for the following reasons per the IRS in Publication 523:
A work-related move
- You took or were transferred to a new job in a work location at least 50 miles farther from the home than your old work location.
Health related move
- Doctors recommends a change in residence due to a health problem.
- You moved to obtain, provide, or facilitate diagnosis, cure, mitigation, or treatment of disease, illness, or injury for yourself or a family member.
- You moved to obtain or provide medical or personal care for a family member suffering from a disease, illness, or injury.
- Any of the above is true for your spouse.
Unforeseeable event
- Your house was condemned or destroyed.
- Your home suffered a casualty loss because of a natural or man-made disaster or an act of terrorism.
- You, your spouse, a co-owner of the home, or anyone else for whom the home was his or her residence:
- Died;
- Became divorced or legally separated;
- Gave birth to two or more children from the same pregnancy;
- Became eligible for unemployment compensation;
- Became unable, because of a change in employment status, to pay basic living expenses for the household (including expenses for food, clothing, housing, medication, transportation, taxes, court-ordered payments, and expenses reasonably necessary for making an income).
- An event is determined to be an unforeseeable event in IRS published guidance.
Other facts and circumstances
- This can be vague, and a lot of things could potentially qualify. A good idea is to develop a fact pattern and provide all documentation to potentially prove your case to your accountant or CPA. Some of the most important facts that may determine whether you qualify are:
- The situation causing the sale arose during the time you owned and used your property as your residence.
- The home was sold not long after the situation arose.
- You couldn’t have reasonably anticipated the situation when you bought the home.
- You began to experience significant financial difficulty maintaining the home.
- The home became significantly less suitable as a main home for you and your family for a specific reason.
Partial Gain Calculation Step 1
If you meet one of these criteria in relation to your home sale, then you may be eligible for a partial gain exclusion which is great. However, the question remains, “How do I calculate the home gain exclusion?”. Well to calculate it you need to refer to the IRS’ Worksheet 1 of Publication 523, Section B. In Step 1 the user can claim the shortest period of the following:
- Your time of residence in the home during the 5-year period leading up to the sale.
- Your time of ownership of the home leading up to the sale.
- The time that has elapsed between the sale and the date you last sold a home for which you took the exclusion, if applicable.
Partial Gain Calculation Step 2, 3 and 4
Once you find the shortest timeframe of those 3 then move onto Step 2. In Step 2, divide the number by 730 if using days and 24 if you used months to calculation the number in Step 1. In Step 3, multiply that number by $250,000 to get your partial gain exclusion. An example of this would be, if you qualified for a partial gain exclusion due to a work-related move and then you went to Worksheet 1 in IRS Publication 523 and then found that in Step 1, option 2 was the shortest as you only lived in the home for 1 year leading up to the sale. You would then take 12 months and divide it by the 24 months. Which is the amount of time needed to live in the house to have a full deduction.
The result of this equation is .5 (12/24). Then you take .5 and multiply it by $250,000 to get a partial gain exclusion of $125,000. And let’s say you bought the house for $100,000 and sold it for $300,000. Normally the $200,000 gain would be taxable because you didn’t qualify for a full exclusion. However, since you did qualify for a partial exclusion of $100,000 you would only be taxed on $100,000 of gains instead of $200,000. Step 4 is repeating this process if you are married filing jointly.
Conclusion
In summary, things happen and sometimes you need to sell a house, fast. Sometimes, this means missing out on a full capital gain exclusion on the sale of you home. If that is the case don’t panic, you may qualify for a partial gain exclusion. If that is the case be sure to consult a Certified Public Accountant and give him or her all the details behind the home sale. The more information you can provide the better. Ideally it would be best to stay in the house for at least 2 years. However, if you receive a 1099-S be sure to send it off to your CPA come tax time.