Do You Pay Capital Gains Tax on Your Primary Residence?
A major tax exclusion on home sale profits exists, but qualifying isn't automatic. Understand the IRS eligibility tests and how to calculate your home's adjusted basis.
When you sell a property for more than you paid, the profit is a capital gain and can be subject to federal taxes. The Internal Revenue Service (IRS) provides a tax benefit for homeowners selling their primary residence. This provision can reduce or even eliminate the tax bill from a home sale, allowing you to keep more of your profit.
The Primary Residence Exclusion
The tax code’s Section 121 exclusion allows you to exclude a large portion of the gain from the sale of your main home from your income. Single individuals can exclude up to $250,000 of the gain. For married couples filing a joint tax return, the exclusion amount is $500,000. If your profit is below these thresholds, you likely will not owe capital gains tax on the sale.
To qualify, you must meet two primary tests. The ownership test requires you to have owned the home for at least two of the five years leading up to the sale date. The use test requires you to have lived in the home as your primary residence for at least two of the five years before the sale. The 24 months for each test do not have to be continuous.
For married couples to claim the full $500,000 exclusion, only one spouse needs to meet the ownership test, but both must meet the use test. You are not eligible to claim the exclusion if you have already excluded the gain from another home sale within the two-year period before the current sale. You can only have one primary residence at a time.
The exclusion is for your main home, not for investment properties or second homes. The proceeds from its sale are not required to be reinvested into another home to qualify for the tax break.
Calculating Your Home Sale Gain or Loss
To determine if you owe taxes, you must first calculate the gain from your home sale. The formula is the selling price minus your selling expenses and the property’s adjusted basis. The result is your total gain or loss.
The selling price is the total amount the buyer paid. From this, you subtract selling expenses, which reduce your calculated gain. These costs include:
- Real estate broker’s commissions
- Title insurance fees
- Legal fees
- Advertising costs
- Any other closing fees you paid
Determining your adjusted basis begins with the initial basis, which is the price you paid for the home. This basis increases with capital improvements that add value, prolong the home’s life, or adapt it to new uses. This is different from routine maintenance or simple repairs.
Examples of capital improvements include:
- Adding a new room
- Finishing a basement
- Installing a new roof
- Paving the driveway
Routine maintenance like painting or fixing a leak does not increase your basis. For example, if you bought your home for $300,000 and spent $50,000 on a kitchen remodel, your adjusted basis becomes $350,000. This higher basis reduces your potential gain when you sell.
Partial Exclusions and Special Situations
You may qualify for a partial exclusion if you do not meet the full two-year tests but sell your home due to a change in employment, a health issue, or another unforeseen event. In these cases, the exclusion is prorated. For example, living in the home for 12 months before moving for a new job meets 50% of the use requirement, allowing you to exclude 50% of the standard amount.
The situation is different if you used part of your home for business or as a rental property. If you claimed depreciation deductions for a home office or rental use, you cannot exclude the portion of your gain equal to that depreciation. This gain is “recaptured” and taxed. For instance, if you lived in one unit of a duplex and rented the other, only the gain from your personal unit is eligible for the exclusion.
Special rules exist for a surviving spouse. If your spouse dies and you have not remarried at the time of sale, you may qualify for the full $500,000 exclusion. The sale must occur within two years of your spouse’s death, and you must meet the other standard requirements.
How to Report a Home Sale
Whether you must report your home sale to the IRS depends on your situation. If the entire gain is covered by the exclusion and you do not receive a Form 1099-S, you do not have to report the sale. Reporting is mandatory if you receive a Form 1099-S or if any portion of your gain is taxable.
Form 1099-S, “Proceeds From Real Estate Transactions,” reports the gross proceeds from the sale and is issued by the closing agent. Receiving this form means the IRS has been notified of the sale. You must report the sale on your tax return, even if you owe no tax.
When reporting is required, you will use Form 8949, “Sales and Other Dispositions of Capital Assets,” to detail the sale. The totals from Form 8949 are then transferred to Schedule D (Form 1040), “Capital Gains and Losses.” These forms allow you to calculate your gain, apply your exclusion, and determine any final taxable amount.