Your Tax Advantage When Selling a Home: Exclusion of Gain

In many cases, the sale of your principal residence can be a major step forward in building your wealth. How? This relates to the capital gains tax exclusion, sometimes referred to as “Exclusion of Gain,” which may allow you to generally exclude up to $250,000 of the gain from your taxable income, or up to $500,000 if you file jointly with your spouse.

But as with most things in the tax code, it’s not that simple. First, you must pass an eligibility test that the IRS uses to determine if you qualify for the exclusion. For most people, this is a three-step process.

Eligibility Step 1: Ownership

You must have owned your home for at least 24 months out of the previous five years. For married couples filing jointly, only one spouse must meet this requirement.

Eligibility Step 2: Residence

If you used your home as your principal residence for at least 24 months of the previous five years, you meet the residence requirement. And those 24 months do not have to occur in one single block of time; they can be spread out across the five-year period. But if you are a married couple filing jointly, both spouses must meet the residence requirement to get the full exclusion.

However, if you own or live in more than one home, a facts and circumstances test will be applied to determine which is your primary residence.

The most important factor is where you spend most of your time, but other factors are important as well.

They include whether the address you’re claiming as your primary residence is on your voter registration card, federal and state tax returns, driver’s license or car registration, and other official documents.

It is also important that your home is near where you work and bank, where one or more of your family members resides, and any recreational clubs or religious organizations of which you are a member. The more of these and other factors that are true, the more likely it is considered your primary residence.

Eligibility Step 3: Look-Back

You can only take this exclusion once every two years. So, if you didn’t sell another home in the two years before the sale date of your current home, or if you did but didn’t take the exclusion, you could meet the look-back requirement.

Bob and Carol: A Hypothetical Scenario

Let’s look at a hypothetical case study with Bob and Carol, in which, for ease of comparison, we‘ll use Jan. 1 for each significant date.

The scenario: Bob and Carol live in Washington, D.C., where they’ve owned and lived in a home since Jan. 1, 2014. On Jan. 1, 2020, they purchased a lake house outside of Washington where they decided to spend their weekends.

On Jan. 1, 2020, Carol retired and moved to the lake house. Bob stayed in the Washington house during the workweek and joined Carol at the lake house on weekends. On Jan. 1, 2024, Bob retired and moved to the lake house, which they then declared as their principal residence.

If they decide to sell their Washington home on Jan. 1, 2024, when Bob retires, do they meet the requirements to take all, some, or none of the capital gains exclusion? Let’s take a look.

Eligibility Step 1: Ownership - They’ve both owned the home for at least two of the last five years, so they meet the criteria for this step.

Eligibility Step 2: Residence - For Bob, it’s easy, as this has always been his residence. Carol also qualifies because she used the home as her principal residence from Jan. 1, 2019, to Jan. 1, 2022, or three out of the previous five years. However, they would have to close the sale of the house by Jan. 1, 2025, or Carol would no longer pass this step.

Eligibility Step 3: Look-Back - They also meet the criteria for this step because there’s no indication that they’ve used this exclusion in the past 24 months.

So, in this case, they can sell the Washington home and take the full $500,000 exclusion.

Additional Considerations for Rental Properties

While the above steps apply to your principal residence, rental properties have different rules. If you’re selling a rental property, you might be concerned about capital gains tax. Here are some strategies to consider:

1031 Exchanges

A 1031 exchange, named after IRS Code Section 1031, allows you to defer paying capital gains tax on an investment property when it is sold, as long as another similar property is purchased with the profit gained by the sale. This can be a powerful tool for real estate investors looking to grow their portfolios without immediate tax consequences.

How to Avoid Paying Capital Gains Tax on Sale of Rental Property

1. Convert the Property to Your Principal Residence: If you convert your rental property to your principal residence and live there for at least two years, you may qualify for the capital gains exclusion under Publication 523.
2. Long-Term Ownership: Holding onto the property for a long-term period can help reduce the tax impact, as long-term capital gains tax rates are generally lower than short-term rates.
3. Utilize Deductions: Make sure to take advantage of all possible deductions related to the property, such as depreciation, which can reduce your taxable income.

Test Your Knowledge: When Does the Lake House Qualify for a Capital GainExclusion?

Now just for fun, let’s look at the lake house. If we assume Bob and Carol sell the Washington home on Jan. 1, 2024, when can they sell the lake house and exclude additional gains? Again, let’s look at the eligibility test.

Eligibility Step 1: Ownership - They’ve already owned the lake house for two years out of the last five years, so they meet this test.

Eligibility Step 2: Residence - The rule says they have to live for two years of the last five in the primary home and that both spouses must individually meet this requirement. Carol already meets this as she began residing at the lake house as her primary home on Jan. 1, 2022. Bob moved in Jan. 1, 2024, so he would not qualify until Jan. 1, 2026, or after.

Eligibility Step 3: Look-Back - They would need to wait at least two full years from the date of the closing on the Washington home to qualify, as you can only take the exclusion one time per two-year period.

So, if they sell the lake house after Jan. 1, 2025, and the close is at least two full years from the closing date of the Washington house, they could take the full $500,000 exclusion again.

If you are thinking of selling your home, or any property, contact your tax professional to help you determine if this strategy can work for you and help you with this process to make sure you receive any exclusion(s) you’re eligible to receive.