What Is the Home Sale Exclusion in Real Estate?
Selling your main home? Understand the tax rules that allow you to exclude a significant amount of profit from your capital gains tax.
The home sale exclusion is a tax benefit available to homeowners when they sell their primary residence. This provision, found in Section 121 of the Internal Revenue Code, allows individuals to exclude a portion of the profit, or capital gain, from their taxable income. The purpose is to reduce the tax burden associated with selling a main home.
Determining Your Eligibility for the Exclusion
To qualify for the home sale exclusion, you must satisfy three conditions: the ownership test, the use test, and the look-back test. The ownership test requires that you have owned the property for at least two years during the five-year period ending on the date of the sale. This ownership does not need to be continuous, and for married couples seeking the full exclusion, only one spouse needs to meet this requirement.
The use test 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 of use do not have to be a single, unbroken period. For example, if you lived in your home for 18 months, moved out for a year, and then moved back in for another six months before selling, you would meet the 24-month requirement. For married couples to qualify for the larger exclusion amount, both spouses must meet the use test.
Finally, the look-back test ensures that you have not used the exclusion for another home sale within the two-year period prior to the current sale.
Calculating Your Capital Gain and Exclusion Amount
The maximum amount of gain you can exclude from your income is $250,000 for single filers and $500,000 for married couples filing a joint return. The calculation begins with the home’s selling price, which is the gross amount you received from the buyer. From this price, you subtract any selling expenses you incurred.
Selling expenses include costs such as real estate broker’s commissions, advertising fees, legal fees, and seller-paid loan charges for the buyer. For example, if you sold your home for $400,000 and paid a 6% real estate commission ($24,000) plus $1,000 in legal fees, your amount realized would be $375,000.
The next step is to determine your home’s adjusted basis, which is subtracted from the amount realized to find your capital gain. The basis starts with the original purchase price of the home. This initial basis is then increased by the cost of capital improvements, which are investments that add value to the home, prolong its life, or adapt it to new uses. Examples include adding a new room, installing a new HVAC system, or replacing the roof.
It is important to distinguish capital improvements from simple repairs. Repairs, such as painting a room or fixing a leaky faucet, are considered maintenance and do not increase your adjusted basis. The formula is: (Selling Price – Selling Expenses) – Adjusted Basis = Capital Gain.
Rules for Partial Exclusions
Homeowners who sell their property before meeting the two-year ownership and use requirements may still be eligible for a partial exclusion. This exception applies if the primary reason for the sale is a change in employment, a health-related issue, or an unforeseen circumstance. For instance, a move for a new job must meet a distance test to qualify.
Health-related reasons can include needing to move to obtain medical care for yourself or a family member, or a doctor’s recommendation to change residences for health purposes. The category of unforeseen circumstances covers a range of events, such as divorce, natural disasters that damage the home, or a change in employment status that leaves you unable to afford the mortgage payments.
The calculation for a partial exclusion is prorated. It is based on the portion of the two-year period that you met the ownership and use tests. For example, if a single individual lives in a home for one year (12 months) and then moves for a qualifying reason, they have met 50% of the two-year requirement. Therefore, they would be entitled to 50% of the standard $250,000 exclusion, which amounts to $125,000.
How to Report a Home Sale
If your entire gain is covered by the exclusion, you do not have to report the sale to the IRS. Reporting becomes mandatory under certain conditions. You must report the sale if:
- You receive Form 1099-S, Proceeds From Real Estate Transactions, from the closing agent.
- Your gain exceeds your maximum exclusion amount.
- You are choosing to claim a partial exclusion for which you qualify.
When reporting is necessary, the transaction is detailed on Form 8949, Sales and Other Dispositions of Capital Assets. The information from Form 8949 is then transferred to Schedule D (Form 1040), Capital Gains and Losses.