Tax Implications of Selling a Primary Residence After 2 Years

Selling a primary residence involves navigating specific tax regulations concerning the length of time you have owned and lived in the property. The two-year mark is a milestone for homeowners because it determines whether the profit from the sale is subject to taxation. Homeowners may be able to exclude a large portion of the gain from their income if they meet certain criteria established by the Internal Revenue Service (IRS).

Determining Your Home’s Cost Basis and Capital Gain

To calculate the profit, or capital gain, you must first determine your home’s cost basis. The basis is its original purchase price, plus certain settlement fees and closing costs you paid when you bought the property, such as abstract fees, legal fees, and surveys. These are distinct from costs associated with getting a mortgage, like points, which are generally not added to the basis.

The cost basis can be adjusted over time. These adjustments involve the cost of capital improvements that add value to your home, prolong its useful life, or adapt it to new uses. Examples include adding a new room, installing a new roof, or paving the driveway. These are different from routine repairs and maintenance, such as painting a room or fixing a leak, which do not increase your basis.

Once you have established the adjusted cost basis, you can calculate your capital gain. The formula is the home’s selling price minus any selling expenses, and then minus the adjusted cost basis. Selling expenses can include real estate broker’s commissions, title insurance, and legal fees paid as part of the sale.

Meeting the Eligibility Requirements for Tax Exclusion

The tax code provides a benefit for homeowners selling their primary residence, known as the Section 121 exclusion. This rule allows you to exclude a substantial amount of capital gain from your taxable income. For single individuals, the exclusion amount is up to $250,000, while for married couples filing a joint return, the amount doubles to $500,000. To receive this benefit, you must satisfy three specific tests.

The first is the ownership test, which requires that you have owned the home for at least two of the five years immediately preceding the date of sale. The second is the use test, which mandates that you must have lived in the home as your main residence for at least two of the five years leading up to the sale. The two years for the ownership and use tests do not have to be continuous or the same two-year periods.

The final requirement is the look-back period. This test stipulates that you cannot have used the exclusion for the sale of another home within the two-year period ending on the date of the current sale. For married couples to qualify for the full $500,000 exclusion, both spouses generally must meet the use test, although only one needs to meet the ownership test.

Exceptions for a Partial Tax Exclusion

Homeowners who sell their property before meeting the two-year ownership and use requirements may still be eligible for a partial tax exclusion. This relief is granted if the primary reason for the sale is related to a change in employment, health, or other unforeseen circumstances.

A change in employment generally qualifies if the new job is at least 50 miles farther from the home than the old job was. Health-related reasons can include moving to obtain or provide care for a disease or injury for the homeowner or a family member. The IRS also provides several “safe harbor” reasons that automatically qualify as unforeseen circumstances.

• The death of a spouse, co-owner, or other qualified person residing in the home.
• Divorce or legal separation.
• The birth of two or more children from a single pregnancy.
• Becoming eligible for unemployment compensation.
• A change in employment that leaves the homeowner unable to pay housing costs.
• A natural disaster that causes a casualty to the home.

If you qualify for a partial exclusion, the amount is prorated. The calculation is based on the portion of the two-year requirement you fulfilled. For instance, if you lived in the home for 18 months (1.5 years) before selling due to a qualifying reason, you would be eligible for 75% of the full exclusion amount (1.5 years divided by 2 years). This would amount to an exclusion of $187,500 for a single filer or $375,000 for a married couple filing jointly.

Reporting the Home Sale to the IRS

The process for reporting a home sale to the IRS depends on whether your entire gain is excludable and whether you received a Form 1099-S, Proceeds From Real Estate Transactions. If you meet the criteria for the full exclusion and did not receive a Form 1099-S, you generally do not need to report the sale on your tax return. This simplifies the process for many homeowners.

You must report the sale if you cannot exclude the entire capital gain or if you receive a Form 1099-S. The transaction is reported on Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you will provide details of the sale, including the date you acquired and sold the property, the sales price, and the cost basis.

The information from Form 8949 is then carried over to Schedule D, Capital Gains and Losses. If you are excluding a portion of the gain, you will indicate this on Form 8949 by making an adjustment. Any non-excludable gain will be calculated and will then flow from Schedule D to your main Form 1040, where it becomes part of your taxable income.