Many taxpayers continue to be confused about tax issues surrounding the sale of their personal residence. Recent changes in the tax law offer a possible exclusion of $250,000 or $500,000, for a joint return, on the gain from your home sale. Prior to these changes, you often had to do careful tax planning and maintain more records to avoid tax on a gain. Certain tests must be met to qualify for the exclusion that makes most home sales exempt from tax on a gain. You can use the exclusion only once every two years. Any reportable gain is shown on IRS Form 1040, Schedule D.
The home you sell must be your principal residence. During the five years prior to the sale date, you must have owned and used the home as your principal residence for at least two years. Should you file a joint return, either of you can meet the ownership test but both of you must conform to the use test. Regardless of how long you live in the home, you may not deduct a loss. The loss is shown on Schedule D, but not allowed.
What happens if you sell the home prior to meeting the two-year test? You may be able to claim a partial exclusion if the sale was the result of a health problem, change in employment, or unforeseen circumstances such as divorce or death of a spouse. The percentage of the two-year time lived in the home is calculated using an IRS worksheet. If you lived in the home for one year or 50%, you could take either exclusion: $125,000 on a single filer return or a $250,000 on a joint return which would reduce the taxable gain.
Renting your home or claiming a home office deduction does not affect the exclusion as long as you meet the two-year rule. However, if you depreciated the home during the rental period or for the home office portion, you would have a taxable depreciation recapture and need to prorate the gain on the home office. The depreciation recapture would cover deductions used after May 6, 1997. Should you have a gain on a multi-family home where a portion of the building was your qualified home, you would treat the gain as being two sales. The first would be that portion allocated to your home with the use of the exclusion and the second would be taxable.
You cannot claim the exclusion for a vacation home unless it is your actual principal residence. You may sell your main home and move into the vacation home. After meeting the two-year test, you can then sell the vacation home as your principal residence for two years. A principal residence can be a mobile home, boat, condominium, or trailer.
A home destroyed or condemned may qualify for an exclusion if you have a gain. Any gain not covered by the exclusion can often be postponed by buying a replacement property.
The exclusion is not mandatory. Under certain circumstances you may own two homes which qualify for a period of time. Should you sell both homes in the same tax year you may apply the exclusion to the sale that produces the least tax.
Separate residences create an unusual application of the exclusion rules. If each spouse meets the test, they may deduct a $250,000 exclusion for each home whether they file a joint or separate return.