Capital Gains Tax When Selling a Home

When you sell your home, the profit you make is considered a capital gain and can be subject to federal taxes. This tax applies to the difference between the home’s selling price and what you paid for it, not the entire sale amount. However, the tax code provides a significant benefit for individuals selling their primary residence, often called the home sale exclusion. This relief can shield a large portion of your profit from being taxed, and for many homeowners, the profit is entirely tax-free.

The Main Home Sale Exclusion

The Internal Revenue Code (IRC) Section 121 provides a substantial tax exclusion for gains from the sale of a main home. To be eligible, you must satisfy two primary conditions: the ownership test and the use test. The ownership test requires that you have owned the property for at least two of the five years immediately preceding the date of sale. This ownership does not need to be a single, unbroken period.

The use test mandates that you must have lived in the home as your primary residence for at least two of the five years leading up to the sale. Similar to the ownership test, these two years do not have to be continuous. The IRS allows for short, temporary absences, such as vacations, to be counted as periods of use. It is possible to meet the ownership and use tests during different two-year periods, as long as both are met within the five-year window ending on the sale date.

If you meet these tests, you can exclude a significant amount of gain. For single individuals, the maximum exclusion is $250,000. For married couples filing a joint return, this amount doubles to $500,000. To qualify for the full $500,000 exclusion, at least one spouse must meet the ownership test, and both spouses must meet the use test.

You can only claim this exclusion once every two years. If you sold another home and excluded the gain from that sale within the two-year period ending on the date of the current sale, you are not eligible to take the exclusion again. This look-back rule prevents taxpayers from repeatedly buying and selling homes to generate tax-free profits in a short time.

Calculating Your Capital Gain

To determine if your profit is excludable, you must first calculate the total capital gain. The formula is your amount realized minus your adjusted basis. Keeping accurate records of all transactions related to your home is necessary to complete this calculation.

Your amount realized is the gross selling price of the home less any selling expenses. These expenses must be directly related to the sale and can include:

• Real estate broker’s commissions
• Title insurance fees
• Legal fees
• Advertising costs
• Escrow fees

For example, if you sell your home for $400,000 and pay $24,000 in commissions and other closing costs, your amount realized is $376,000.

Your adjusted basis starts with the original purchase price and is increased by the cost of capital improvements. These are projects that add value to the home, prolong its useful life, or adapt it to new uses, such as adding a room or replacing the roof. For instance, if you purchased your home for $250,000 and spent $50,000 on a major kitchen remodel, your adjusted basis would be $300,000.

Simple repairs and maintenance, like painting a room or fixing a leaky faucet, do not count as capital improvements and cannot be added to your basis. Your basis can also be decreased by certain items, such as previously claimed casualty loss deductions or energy credits.

Partial Exclusions and Special Rules

Partial Exclusion

You may qualify for a partial exclusion even if you do not meet the two-year ownership and use tests. This can occur if the primary reason for the sale is a change in employment, for health reasons, or due to an unforeseen event as defined by the IRS. You can exclude a fraction of the standard limit, prorated for the portion of the two-year period you met the requirements.

Surviving Spouses

A surviving spouse may be able to claim the full $500,000 exclusion. To qualify, they must sell the home within two years of their spouse’s death, have not remarried at the time of sale, and the couple must have met the joint requirements immediately before the death.

Divorce

If a home is transferred to a spouse as part of a divorce settlement, the recipient can often count the ownership and use periods of the transferring spouse. For example, if one spouse moves out but the other remains in the home under a divorce decree, both may still meet the use test for that period.

Nonqualified Use

The exclusion can be limited if the property had periods of nonqualified use. This refers to any time after 2008 when the property was used as a rental or a second home instead of your primary residence. The portion of the gain from this nonqualified use is not eligible for the exclusion.

Reporting the Home Sale on Your Tax Return

You are not required to report the home sale to the IRS if the entire gain is excludable. However, you must report the sale if you receive a Form 1099-S, Proceeds From Real Estate Transactions, even if you owe no tax. The closing agent issues this form.

You are required to report the sale if you cannot exclude the entire gain. This applies if your profit exceeds the exclusion limit or if you do not qualify for the exclusion for other reasons.

Reporting a taxable gain involves two main forms. First, use Form 8949, Sales and Other Dispositions of Capital Assets, to list the transaction details like sale price and basis. The totals from Form 8949 are then carried over to Schedule D (Form 1040), Capital Gains and Losses. On Form 8949, you report the full gain and then list the exclusion amount as a separate adjustment to find the correct taxable gain.