How the Personal Residence Exclusion Works

The personal residence exclusion, formally known as the Section 121 exclusion, is a provision in the U.S. tax code that allows homeowners to avoid paying taxes on a portion of the profit from selling their main home. The exclusion reduces the tax burden on what is, for many people, their most significant asset. This tax benefit permits qualifying individuals to exclude up to $250,000 of gain from their taxable income, and married couples filing jointly can exclude up to $500,000.

Qualification Requirements for the Exclusion

To benefit from the personal residence exclusion, a taxpayer must satisfy tests centered on ownership and use of the property. The ownership test requires that you have owned the home for at least two years (730 days) during the five-year period ending on the date of the sale. The use test mandates that you must have lived in the home as your primary residence for at least two of the five years immediately preceding the sale. For both tests, the two-year period does not need to be continuous.

The ownership and use periods do not need to overlap; a taxpayer could meet the ownership test during one two-year period and the use test during a different two-year period within the five-year window. Determining which property qualifies as a “main home” is a matter of facts and circumstances if a taxpayer owns more than one residence. The IRS will consider where the taxpayer spends the majority of their time, and evidence to support a property’s status as a main home includes the address listed on:

• Federal and state tax returns
• A driver’s license
• Voter registration cards
• Correspondence from banks and other institutions

The physical location of the home, whether a traditional house, houseboat, or condominium, is less important than its function as the taxpayer’s primary dwelling.

A taxpayer is prohibited from using the exclusion if they have already excluded gain from the sale of another home within the two-year period ending on the date of the current sale. This rule prevents individuals from repeatedly buying and selling homes to generate tax-free profits in short succession.

Calculating the Exclusion Amount

The maximum exclusion is $250,000 of the gain for a single individual. For married couples filing a joint tax return, the exclusion can be up to $500,000.

To qualify for the full $500,000 exclusion, a married couple must file a joint return for the year of the sale. Additionally, at least one spouse must meet the two-out-of-five-year ownership test, and both spouses must meet the two-out-of-five-year use test. If these specific requirements are not met, the couple may be limited to the $250,000 amount.

The total gain on the sale is the selling price minus the property’s adjusted basis. The selling price is the gross price reduced by any selling expenses, which include:

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

The adjusted basis of the home starts with the original purchase price. To this initial cost, you add certain settlement fees and closing costs that were incurred at the time of purchase, such as abstract fees and recording fees. The basis is then increased by the cost of any capital improvements made to the property. Capital improvements are distinct from simple repairs; they add value to the home or prolong its life, such as adding a new room or installing a new roof, whereas fixing a leaky faucet is a repair and does not increase the basis.

Special Circumstances and Partial Exclusions

Partial Exclusion for Early Sales

If the primary reason for selling the home is a change in health, a change in place of employment, or certain other unforeseen circumstances as defined by the IRS, a prorated exclusion may be available even if you fail to meet the two-year tests. The amount of the partial exclusion is calculated based on the portion of the two-year requirement that was met.

Nonqualified Use

Any period of “nonqualified use” after December 31, 2008, can limit the amount of gain eligible for the exclusion. Nonqualified use refers to any time the property was used as a rental, a vacation home, or for any purpose other than as the taxpayer’s main home. The portion of the gain attributable to these periods of nonqualified use is not excludable and must be recognized as taxable income.

Depreciation Recapture

If you claimed depreciation deductions on the home, for a home office for instance, those deductions must be “recaptured” upon the sale. This means that the amount of gain equal to the depreciation claimed after May 6, 1997, cannot be excluded under the personal residence rules. This recaptured amount is taxed at a specific rate for unrecaptured Section 1250 gain, which is typically higher than standard long-term capital gains rates.

Reporting the Home Sale on Your Tax Return

The requirement to report a home sale to the IRS depends on whether you received a Form 1099-S, Proceeds From Real Estate Transactions, and whether your gain exceeds your maximum exclusion. If you receive a Form 1099-S, you must report the sale on your tax return even if the entire gain is excludable. Reporting is also mandatory if you have a gain that is not fully covered by your exclusion or if you are claiming a partial exclusion. If your entire gain is excludable and you did not receive a Form 1099-S, you may not need to report the sale.

When reporting is necessary, the sale is detailed on Form 8949, Sales and Other Dispositions of Capital Assets. This form is where you list the property’s sales price, its cost basis, and calculate the total gain. The information from Form 8949 then flows to Schedule D, Capital Gains and Losses, which is filed with your Form 1040. To claim the exclusion, you will enter the excludable amount as a negative number in the adjustment column, using a specific code designated by the IRS to indicate a principal residence exclusion. This entry subtracts the non-taxable portion of your gain, ensuring that only the taxable amount is carried forward to Schedule D.