There are always a lot of questions when it comes to people’s primary residences. These inquiries generally pertain to capital gains and losses along with deductibility of certain expenses. With the insane increase in the value of homes in the United States over the last thirty years, this issue makes sense to those who have lived in the same house for decades. I address all these issues in this post, so you don’t have to wonder any longer.

For years, the IRS has applied incredibly generous tax rules for any capital gain on the sale of a taxpayer’s main home. How generous? Well, in most instances up to a $250,000 capital gain for single filers and $500,000 for married joint filers can be excluded. That means no taxes on the gain at all up to the applicable limit. Furthermore, most of the time you don’t even have to account for this gain on your return, meaning there’s no need to mention it. Quite frankly, this is seen nowhere else in the tax code that I know of. You almost always have to at least account for exempt gains. And even when you have to account for it, you still never have to pay taxes on it, assuming it’s below the limit for your filing status. But with this great tax benefit there is a reciprocal catch, so to speak, which is that you cannot deduct net capital losses from the sale of your primary residence.

Note that for the capital gain exclusion to apply you have to sell your main home, of which you can only have one. The definition of “main home” as applied to the rule includes a house, houseboat, mobile home, cooperative apartment, or condominium. Furthermore, your main home is the one that you live in most of the time, so a majority of the year, and therefore not a vacation house or a guest house on the same property as your actual main home. So you can’t pull a fast one and sell an extra house and claim it’s your main home. The IRS has thought of that one.

Furthermore, to obtain the exclusion you must have owned and lived in the home you sold for two of the last five years, with the end of the five year period corresponding to the date of the sale. Note that in terms of living in the home, these years do not have to be consecutive. You can live in a house for a year and then move to an apartment, live there for three years, and then move back to the house for another year. Under these circumstances, and as long as you didn’t rent out your home in the interim, the house you lived in the last year would be your main home, and all other things being equal would apply for the $250,000/$500,000 exclusion. This is due to the fact that you lived in that house for two of the five years. The three year gap in the middle didn’t change that.

Moreover, if you’re married and you’re going for the greater $500,000 exclusion there are additional requirements. Those are: file a joint return; either you or your spouse has owned the house for two years; both you and your spouse have lived in the house for two years; and neither you nor your spouse has excluded a gain from the sale of a home in the last two years. All is not lost if you and your spouse don’t meet all the requirements because you can still take the single exemption amount of $250,000 if one of you meets the requirements of ownership and use that generally apply.   

The rules that apply to the exemption are not completely hard and fast though. For example, if you’re physically or mentally incapable of caring for yourself and you lived in your home for a total of one year out of the last five, and you also owned that home for two of the last five, then you pass the test and can exempt the capital gain from the home’s sale up to the limit. Another exception occurs when your home is destroyed or condemned. Under those circumstances, you can move into a replacement home and tack the time you lived in and owned your previous home that was destroyed or condemned onto the new home. As a final exception, members of the armed services can also suspend the five year period of both ownership and use to accommodate active deployment overseas.

You can even get an exemption of the capital gain, albeit reduced, from the sale of your home, if you use it for rental property for a period of time. The way this works is that looking at the five year period which ends on the date of sale, the percentage of time the home was rented out to tenants is calculated and then multiplied by the full amount of the exemption, which gives you the amount that the full exemption must be reduced by. However, rental periods that continue from the time the owner stops using the property as his or her main home until the property is sold don’t count as nonqualified periods and therefore don’t reduce the amount of the exemptions. For example, if I, as a single person, own and live in a home for the first two years and then I move and rent it out to tenants for the following three years and then sell it, this rental period, which would usually function to reduce my capital gain exemption, does not do so, and I can take up to the full exemption of $250,000.

Shifting gears slightly, the formula for obtaining the amount of gain or loss you have associated with the sale of your main home is:

                [(Sales price) – (Expenses associated with sale)] – Adjusted basis = Gain or loss    

Explaining the above formula, you subtract the expenses you incur from selling your house, like brokerage fees, commissions, advertising fees, and legal fees, from the sales price to get the total amount realized from the sale. After which you subtract the adjusted basis from the total amount realized to obtain your gain or loss. Typically the basis is your initial cost in purchasing the house, plus any improvements, and minus depreciation, if any. Note that improvements are not repairs, and further that repairs don’t completely replace something costly. So, if you completely replace something that has a significant cost or add on to your home, then add the cost of the replacement or addition to your home’s basis.

Coming back to a point I just touched on earlier, you’ll have to account for the capital gain from the sale of your main home if you: can only exclude part of the gain; you choose not to exclude the gain (which is insane, but whatever); or you receive a Form 1099-S, Proceeds from Real Estate Transactions. If not used for business purposes, you report the gain from the sale of your home, if you have to, on Form 8949, Sales and Other Dispositions of Capital Assets, on either Part I, box C checked or Part II, box F checked, depending on whether or not you owned your home for over a year. However, if at the time of sale your home was used for business purposes, such as rental for tenants, report the income on Form 4797, Sales of Business Property, Part I. Finally, after initially reporting the gain on either Form 8949 or Form 4797, enter any determined gain on the appropriate line of Schedule D, Capital Gains and Losses.

For more information on the sale of your home, see IRS Publication 17.   

If you need help determining whether the capital gain from the sale of your primary residence is tax exempt, or you have any other tax problem, call Dino Tax Co today at (713) 397-4678 or email davie@dinotaxco.com. Your initial phone consultation is always free and we’re here to answer any of your questions. Also, like us Facebook at www.facebook.com/dinotaxco.