If you sold your home this year or are thinking about putting it on the market, there are many tax-related issues that could apply to the sale of your home. To help you prepare for reporting a sale or make you aware of what issues you may face if you opt to sell your home, this article covers the tax basics and some special situations related to home sales and the home-sale gain exclusion.

Home Sale Exclusion

For decades, Congress has encouraged home ownership by providing various tax breaks for taxpayers selling their homes. Under the current version of the tax code, you are allowed an exclusion of up to $250,000 ($500,000 for married couples) of gain from the sale of your home if you owned and lived in it as your principal residence for at least two of the five years counting back from the sale date. One important note, you cannot have taken a home-sale exclusion within the two years immediately preceding the sale. There is no limit on the number of times you can use the exclusion if you meet these time requirements. The home-sale gain exclusion only applies to your primary residence, not to a second home or a rental property.

Two out of Five Years Rule

As noted above, you must have used and owned the home as your principal residence for two out of the five years immediately preceding the sale. The years don’t have to be consecutive or the closest to the sale date. Vacations, short absences, and short rental periods do not reduce the use period. If you are married, to qualify for the $500,000 exclusion, both you and your spouse must have used the home for two out of the five years prior to the sale, but only one of you needs to meet the ownership requirement. When only one spouse in a married couple qualifies, the maximum exclusion is limited to $250,000 instead of $500,000.

Although this situation is quite rare, if you acquired the home as part of a tax-deferred exchange (sometimes referred to as a 1031 exchange), then you must have owned the home for a minimum of five years before the home-gain exclusion can apply.

If you don’t meet the ownership and use requirements, there are some situations in which a prorated exclusion amount may be possible. An example of this situation would be if you were required to sell the home because of extenuating circumstances, such as a job-related move, a health crisis, or other unforeseen events. Another rule extends the five-year period to account for the deployment of members of the military and certain other government employees. Give us a call if you have not met the two out of five years rule; we can help determine if you qualify for a reduced exclusion.

Business Use of the Home

If you used your home for business and claimed a tax deduction—for instance, for a home office, storing inventory in the home, or using it as a daycare center—that deduction most likely included the home’s depreciation. In that case, up to the extent of the gain, the claimed depreciation cannot be excluded.

Figuring Gain or Loss From a Sale

The first step is to determine how much the home cost, the combination of the purchase price and the cost of improvements. From this total cost, subtract any claimed casualty loss deductions and any depreciation taken on the home. The resulting number is your tax basis. Next, subtract the sale expenses and this tax basis from the sale price. The result is your net gain or loss on the sale of the home. Your mortgage does not affect the taxable gain or loss computation.

If the result is negative, the sale is a loss; losses on a personal-use property such as a home cannot be claimed for tax purposes.

If the result is a gain, subtract any home-gain exclusion (discussed previously) up to the extent of the gain. This is your taxable gain, which is, unfortunately, subject to income tax. If you owned the home for at least a year and a day, the gain will be a long-term capital gain; as such, it will be taxed at the special capital-gains rate, which ranges from zero for low-income taxpayers to 20% for high-income taxpayers. Depending on the amount of all your income, the gain may also be subject to the 3.8% net investment income surtax that was added as part of the Affordable Care Act.

If you have owned your home for 25 years or more, you may face another issue that can affect your home’s tax basis. If you purchased your home before May 7, 1997, after selling another home, the tax rules on home sale gains were different. Instead of a home-gain exclusion of the profit from the home you sold, any gain from the sale would have been deferred to the replacement home. This deferred gain would reduce your current home’s tax basis and add to any gain for the current sale. While this situation is rare now, if it applies to you, be sure to look back in your tax records from the year you purchased your home for information about the reinvested gain deferral.

Prior Use as a Rental

If you previously used your home as a rental property, the law includes a provision that prevents you from excluding any gain attributable to the home’s appreciation while it was a rental. The law’s effective date was the beginning of 2009, meaning that you only need to account for rental appreciation starting that year. This law was passed to prevent landlords from moving into their rentals for two years to exclude the gains from those properties. Before the law changed, some landlords had done this repeatedly.

There are a few other rare home-sale rules we did not include here. As you can see, home-sale computations and tax reporting can be very complicated. If you have recently sold your home or are planning on selling, reach out to the tax experts at Cray Kaiser at (630) 953-4900 if you need assistance planning a sale or post-sale reporting.