Follow the Rules for a Tax-Free Home Sale 

When you are ready to sell your home you are probably focused on your potential profits, particularly if you plan to buy another home with the proceeds from the sale.

While REALTOR® commissions and other closing costs will impact how much you keep from the transaction, fortunately, if you’re like most sellers, you won’t have to pay a capital gains tax on your federal income tax return on profits up to $250,000 or $500,000 depending on how you file your taxes.

The Taxpayer Relief Act of 1997 made it easier for more sellers to qualify for the capital gains tax exclusion. Prior to that date, the exclusion was limited to a once-in-a-lifetime benefit and only to sellers over age 55.

There are a few requirements you must meet to avoid capital gains taxes on your home sale, including:

§  The capital gains tax exclusion is limited to $250,000 of the profits from the sale of your home if you file taxes as a single person and to $500,000 of the profits if you file taxes jointly.

§  You must have lived in your home for at least two of the previous five years. The time that you live in the home doesn’t have to be within the past two years and doesn’t have to be altogether in one solid block, either. You can live there in two different years within the past five years and have that count. You don’t have to be living there when the house is listed for sale, either.

§  If you have used your home as a rental property and want to sell it, make sure you have lived in the home yourself for two of the past five years. In other words, if you lived in it for two years and want to sell it, make sure you sell it before you have rented it for more than three years.

§  Your home must be your principal residence rather than a vacation home or second home to qualify for the tax break.

§  You can invest the profits in anything you want. Before 1997, IRS rules said that you had to reinvest your profits from the sale of one home into another within two years to avoid paying taxes. Since 1997, taxpayers are not required to buy another home.

§  If you are married, you and your spouse cannot have used the capital gains exclusion within two years prior to your transaction.

Partial Exclusion

Even if you don’t qualify for the full capital gains tax exclusion, you may qualify for an exception to the two-year residency rule. Some examples of reasons you could be exempt from the two-year rule include an early move due to:

§  A change in your employment location

§  A health concern that forces you to move

§  Deployment for the military or foreign service

§  Divorce or separation

§  “Unforeseen circumstances,” such as an act of war or terrorism, or multiple births from one pregnancy.

Medicare Tax

The Affordable Care Act of 2010 imposed an additional potential tax on the sale of real estate, but this tax impacts only high-income individuals who earn $200,000 or $250,000 for a couple. This tax, designated to supplement Medicare expenses, imposes a 3.8% tax only on the amount of profit above the exclusion for capital gains taxes.

The only sellers who must pay this tax are those who have an income above the threshold and who also sell a house with profits above the capital gains exclusion. The tax is imposed only on the difference between your profit and the excluded amount, not the full profit.

Consult IRS Publication 523, “Selling your Home,” or consult a tax advisor to make sure you are following the correct rules related to the individual circumstances of your home sale.