How Does the Homeowners Exclusion Work?

A provision in the tax code, known as the Section 121 exclusion, allows individuals to shield a portion of the profit from the sale of their primary residence from taxation. This tax benefit is designed to make it easier for homeowners to relocate without facing a large tax bill on the appreciation of their home’s value.

Qualification Requirements

To benefit from the homeowners exclusion, you must satisfy the Ownership Test and the Use Test. Both tests require you to have owned and lived in the property as your main home for at least two of the five years leading up to the date of sale. These two years do not need to be continuous. For example, you could live in the home for 18 months, move out, and then move back in for another six months to meet the Use Test.

You cannot claim the exclusion if you have already excluded the gain from another home sale within the two-year period before the current sale. The maximum gain you can exclude is $250,000. This amount doubles to $500,000 for married couples filing a joint return. To qualify for the $500,000 exclusion, either spouse can meet the ownership test, but both must meet the use test, and neither spouse can have used the exclusion on another home sale within the last two years.

Calculating Your Capital Gain

Before applying the exclusion, you must determine the capital gain on your home’s sale. The formula is the selling price minus the home’s adjusted basis.

Your home’s adjusted basis starts with the original purchase price. This figure is increased by certain costs, including settlement fees from the purchase and the cost of capital improvements.

Capital improvements are expenses that add value to your home, prolong its life, or adapt it to new uses. Examples include:

• Adding a new room
• Installing a new roof
• Paving the driveway
• Extensively remodeling a kitchen

Repairs, which are routine maintenance like painting a room or fixing a leak, do not increase your basis. For instance, if you purchased your home for $300,000 and spent $50,000 on a new addition, your adjusted basis is $350,000. If you sell the home for $600,000, your capital gain is $250,000.

Special Circumstances and Reduced Exclusions

Reduced Exclusion

Homeowners who sell before meeting the two-year requirements may qualify for a reduced exclusion if the sale is due to a change in employment, a health issue, or other unforeseen circumstances defined by the IRS. For a work-related move, the new job must be at least 50 miles farther from the home than the old one. The reduced exclusion is prorated based on the portion of the two-year period you met the requirements. For example, a single individual who lived in their home for 12 months (50% of the requirement) before selling for a qualifying reason could exclude up to 50% of the $250,000 maximum, which is $125,000.

Nonqualified Use

The exclusion can be limited if the property was used for purposes other than a primary residence, such as a rental or vacation home. This rule applies to periods of “nonqualified use” that occur after 2008. The portion of the gain allocated to nonqualified use is not eligible for the exclusion. The calculation involves determining the ratio of nonqualified use to your total period of ownership, and that percentage of the gain is taxable. Any depreciation claimed on the property while it was used as a rental or for business cannot be excluded and is taxed separately as depreciation recapture.

Surviving Spouses

Special provisions exist for a surviving spouse who sells a main home. A surviving spouse may qualify for the full $500,000 exclusion if the sale occurs within two years of the date of the spouse’s death. To be eligible, the couple must have met the requirements for the $500,000 exclusion immediately before the death, and the surviving spouse must not have remarried before the sale date.

Reporting the Sale on Your Tax Return

You must report the sale of your home on your tax return if you receive Form 1099-S, Proceeds From Real Estate Transactions, or if you cannot exclude the entire capital gain. If your gain is less than your maximum exclusion amount and you meet all other qualifications, you may not need to report the sale unless you received a Form 1099-S.

When reporting is necessary, the transaction is detailed on Form 8949, Sales and Other Dispositions of Capital Assets, and carried to Schedule D, Capital Gains and Losses. On Form 8949, you will list the property’s sale price and its adjusted basis to calculate the total gain. You will then show the full gain and enter the amount of your exclusion on a separate line, which ensures only the taxable portion is carried to your Form 1040. For specific guidance, taxpayers can refer to IRS Publication 523.