Many residential real estate markets are still red hot. Significant home-sale gains are likely even if you’ve only owned your place for a relatively short time, and now have to sell.
If you’ve owned for at least two years, you probably qualify for the lucrative federal income tax principal residence gain exclusion break. Under that deal, unmarried individuals can exclude (pay no federal capital gains tax on) home-sale gains of up to $250,000. Married joint-filing couples can exclude up to $500,000.
But what if you’ve owned your place for less than the required two years? Can you still qualify for a gain exclusion? Answer: You might qualify for a reduced exclusion that would be much better than no exclusion at all. Here’s the story, starting with some necessary background info.
How the gain exclusion on home sales works
As stated earlier, unmarried individuals can potentially exclude home-sale gains of up to $250,000, and married joint-filing couples can potentially exclude up to $500,000. However, you must pass the following tests to be eligible for these maximum exclusion amounts.
The ownership test
You must have owned the property for at least two years during the five-year period ending on the sale date. Two years means periods aggregating 24 months or 730 days.
The use test
You must have used the property as your principal residence for at least two years during the same five-year period.
The married joint-filer test
To qualify for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.
The anti-recycling test
If you excluded an earlier gain within the two-year period ending on the date of a later sale, you are ineligible for the gain exclusion break for the later sale. In other words, the gain exclusion privilege cannot be “recycled” until two years have passed since you used it last.
You may qualify for a reduced gain exclusion if you don’t pass all the tests
What happens when you fail to meet all the aforementioned timing rules?
For example, you might sell your home for a healthy profit after living there only 18 months instead of the required two years. Or you might sell your current home less than two years after excluding gain from the sale of a previous residence. Must you pay tax on the entire gain when you make such a “premature” sale? Not necessarily. IRS regulations allow you to claim a reduced exclusion (some fraction of the full $250,000 or $500,000 amount) in quite a few circumstances.
The reduced exclusion equals the full $250,000 single-filer or $500,000 joint-filer exclusion (whichever applies) multiplied by a fraction. The numerator is the shorter of: (1) the aggregate period of time the property is owned and used as your principal residence during the five-year period ending on the sale date or (2) the period between the last sale for which you claimed an exclusion and the sale date for the home currently being sold. The denominator is two years (12 months or 730 days). That sounds more complicated than it really is. Here are some clarifying examples.
Example 1: You and your spouse file jointly. Due to a job change that required a long-distance move, you sold your home, which you had owned and used as your principal residence for 11 months. Because you bought at the right time, you snagged a $200,000 gain. You’re entitled to a reduced gain exclusion of $229,167 ($500,000 x 11/24). So, you can exclude the entire gain for federal income tax purposes.
Example 2: You sold your previous home 15 months ago and claimed the gain exclusion privilege. Due to health reasons, you’re now about to close on the sale of your current home, which you’ve owned and used as your principal residence for 15 months, for a $125,000 gain. You’re entitled to a reduced gain exclusion of $156,250 ($250,000 x 15/24). So, you can exclude the entire gain for federal income tax purposes.
Eligibility for reduced exclusion
The reduced exclusion deal is only available when you sell your home due to:
* A change of place of employment.
* Health reasons.
* Other unforeseen circumstances, as specified by the IRS.
For details on eligibility for a reduced exclusion, see IRS Publication 523 (Selling Your Home). Read page 6.
The bottom line
The federal home-sale gain exclusion break is one of the best tax-saving deals on the books. And you can qualify in some circumstances that might surprise you.