Taxes on the Sale of a Primary Residence
Navigate the tax implications of selling your home. This involves understanding eligibility for a key exclusion and correctly calculating your true gain.
When you sell your primary home, the transaction can have tax consequences. The profit you realize from the sale is considered a capital gain, and this gain may be subject to federal income tax.
The Primary Residence Exclusion
A provision in the U.S. tax code, known as the Section 121 exclusion, allows many homeowners to avoid paying taxes on the profits from selling their main home. This rule permits an individual to exclude up to $250,000 of the gain from their taxable income. For married couples who file a joint tax return, the exclusion amount doubles to $500,000.
This exclusion applies to the profit from the sale, not the total selling price. For example, if a single filer has a $200,000 gain from a home sale, it falls below the $250,000 exclusion, and no tax would be owed.
The exclusion is only for your primary residence—the home you own and live in most of the time. It cannot be applied to the sale of a second home, vacation property, or a house treated as a rental or investment property.
To use this exclusion, homeowners must meet IRS requirements for ownership, residency, and the timing of previous sales. If the gain from the sale exceeds the available exclusion amount, the excess profit is subject to capital gains tax.
Qualification Rules for the Exclusion
To use the home sale exclusion, you must satisfy three tests. The ownership test requires you to have owned the home for at least two years during the five-year period ending on 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 two years for the use test do not need to be continuous and can be an accumulation of shorter periods. For married couples filing jointly to claim the full $500,000 exclusion, both spouses must meet the use test, but only one spouse needs to meet the ownership test.
The final rule is the look-back period. This rule states that you cannot have used the exclusion for the sale of another home within the two-year period prior to the current sale. If you sold another primary residence and excluded the gain within the last two years, you are ineligible to claim the exclusion again.
Calculating Your Home Sale Gain or Loss
Determining the gain or loss from your home sale involves a specific calculation: the selling price minus your selling expenses and the property’s adjusted basis. A positive number indicates a gain, while a negative number signifies a loss. Losses on the sale of a primary residence are not tax-deductible.
Start with the home’s gross selling price and subtract your selling expenses. These costs include real estate agent commissions, advertising fees, legal fees, title insurance, and any mortgage points you paid on behalf of the buyer.
Next, subtract the home’s adjusted basis, which starts with your original purchase price. This initial basis is then increased by the cost of any capital improvements you made. Capital improvements are long-term upgrades that add value to your home, prolong its life, or adapt it to new uses.
Examples of capital improvements include:
- A new roof
- A room addition
- A remodeled kitchen
- A new HVAC system
Routine repairs, like painting a room, do not affect your basis.
Certain events can decrease your basis. If you used a portion of your home for business or as a rental and claimed depreciation deductions, those deductions reduce your basis. Any energy credits you received for home improvements would also lower your basis.
Partial Exclusions and Special Situations
Homeowners who do not meet the standard two-year ownership and use requirements may still be eligible for a partial exclusion. The IRS allows this if the sale is due to a change in workplace location, a health-related issue, or another unforeseen circumstance. An unforeseen circumstance is an event you could not have reasonably anticipated.
A partial exclusion is prorated based on the portion of the two-year period you met the requirements. For example, meeting the requirements for one year (50% of the two-year period) allows a single filer to exclude up to $125,000 of their gain (50% of $250,000).
Special rules also apply to surviving spouses. If a spouse dies and the surviving spouse has not remarried at the time of the sale, the survivor may be able to claim the full $500,000 exclusion. This is possible if the sale occurs within two years of the spouse’s death and the couple met the requirements before the date of death.
Another situation involves homes partially used for business or as a rental. If you claimed depreciation deductions on a part of your home, such as for a home office, you cannot exclude the portion of your gain equal to the depreciation you claimed. This gain is known as depreciation recapture and is taxed at a maximum rate of 25%.
How to Report Your Home Sale
You may not need to report the sale if your entire gain is covered by the exclusion and you did not receive a Form 1099-S, “Proceeds From Real Estate Transactions.” This is often the case for homeowners whose profit falls below the $250,000 or $500,000 thresholds.
You must report the sale if you received a Form 1099-S, which is issued by the real estate closing agent. You are also required to report it if you have a gain that is not fully covered by your exclusion amount. Furthermore, you must file if you choose not to claim the exclusion.
If you are required to report the sale, the transaction is detailed on Form 8949, “Sales and Other Dispositions of Capital Assets.” The totals from Form 8949 are then transferred to Schedule D, “Capital Gains and Losses,” which is filed with your Form 1040 tax return.