If you have owned your home for more than 20 years, you may be familiar with the old rule on capital gains.  Until the law changed in 1997, homeowners over 55 had a one-time chance to exclude the princely sum of $125,000 on the gain from selling their homes.  Everyone else was required to pay capital gains tax on all the profits from the sale.  The 1997 legislation substantially changed the rules.  Now, any homeowner, regardless of age, is entitled to a statutory exclusion on profits from the sale of the family home.  A single individual can exclude up to $250,000 of gain.  A married couple can exclude up to $500,000. 

What is Capital Gains Tax?

While most experienced homeowners are familiar with the term, first time buyers may not understand the capital gains concept.  Income tax is tax you owe on money you earn from your job or business, money you receive by charging rent on real estate you own, or other earnings that qualify as ordinary income.  Income is taxed at different rates than capital gains.  Capital gains occur when you sell something you own (stocks, real estate, cars) for a profit. Short-term capital gains occur when you sell an asset you have owned for less than a year.  Taxes on short-term capital gains are fairly high and will be significantly higher than those on more long-term ownership.  You have a long-term capital gain if you sell an asset you’ve owner for longer than a year and make a profit.

Ownership Requirements to Use the $250,000/500,000 Exclusion

The Internal Revenue Service has strict rules governing who is and who is not entitled to the capital gains exclusion.

• You must have owned your home for a minimum of two years.
• It must have been your principal residence for 2 years out of the 5 years prior to the sale.
• During the two-year period ending on the date of the sale, you did not sell another home and use the capital gains exclusion.

Unlike the old (pre-1997) law, homeowners can use the capital gains exclusion over and over so long as they meet the requirements.

Home Ownership That Does Not Qualify for the Exclusion

Homeowners who do not meet the criteria will have to pay capital gains tax on the entire gain they realize from selling their property.  Factors that may prevent you from using the exclusion are:

• The house is not your main home or residence.
• You owned the property for less than 2 years before selling it.
• You did not live in the home for at least two years out of the five-year period before you sold.
• You already claimed the exclusion on another house in the past 2 years before selling this house.
• You bought the home through a like-kind exchange.
• You are subject to expatriate tax.  (Usually U.S. citizens who have their residence abroad or who have renounced U.S. citizenship).

How Does the Law Define Gain?

When you sell a home, the “gain” is the home’s selling price minus deductible closing costs, selling costs, and your basis in the property.  Let’s illustrate this with an example.  Tom and Judy have owned and lived in their home for 10 years.  Now, Tom’s company has transferred him to a new city.  They purchased the home for $300,000.  That price is their “basis” in the home.  Now, they have sold the house for $870,000.  Does the entire $570,000 they made over the purchase price qualify as their gain?  No.  There are other factors to consider.  When they apply the $500,000 exclusion for a married couple, there is the additional $70,000 that does not fall within the exclusion.  However, Tom and Judy paid $6,000 of deductible closing costs and a real estate commission to their broker of $50,000.  They can subtract those amounts from the $70,000.  They will owe capital gains tax on the $14,000 of remaining profit.

Home Improvements Can Increase Your Basis

It is very important for homeowners to keep track of home improvements and keep receipts for all the improvements they make.  Why?  Because your basis in the home can include more than the purchase price.  It also includes documented improvements you have made.  If you replaced the windows, remodeled the bathrooms with new flooring and fixtures, added new cabinets and appliances to your kitchen, added a room, replaced cheap carpeting with tile or hardwood floors, or made other significant improvements to the home, those costs can be added to your basis.  John, a single man, bought an older home for $150,000.  Over the course of the last five years, he has landscaped his yard, remodeled the kitchen and bathrooms and replaced all the windows.  In total, John spent $65,000 on home improvements.  He kept all of his receipts.  John recently sold his home for $470,000.  John paid his realtor $20,000 and paid $1000 of the closing costs.  Will he pay capital gains tax?  No.  John’s basis is $150,000 + $65,000.  That makes his total basis in the home $215,000.  When he sold the house for $470,000 and applied his $250,000 exclusion, he was left with $220,000.  His closing costs and realtor fees added to his $215,000 basis more than wipe out any taxable gain.

In contrast, Judy bought an older home for $150,000.  She replaced the worn-out carpet and twenty-year old kitchen stove.  She also replaced the 30-year old air conditioner when it quit working the following year.  Do these types of expenses increase her basis in the home?  No.  Replacing worn out items and flooring are repairs rather than improvements and do not increase your basis.

Exception that Might Apply to Homeowners Who Fail to Qualify for the Exclusion

If you or your spouse are in the military, the Foreign Service, or the U.S. Intelligence Services, you may qualify for the capital gains exclusion under certain circumstances, even if you do not meet the “primary residence” test.  If you are transferred to a duty station more than 50 miles from your home or if government orders require you to live in government housing, you may still be able to use the exclusion when selling your home. 

If your doctor ordered you to move for health reasons, your employer required you to move to another location, or if you have had a significant change in your life due to unforeseen circumstances, you may still qualify for a partial exclusion of capital gains tax.  For example:  you live in a 900 square foot townhouse, and you recently gave birth to triplets. An unforeseen circumstances exception may apply.  The exception would allow you to sell your townhouse and move to a larger home even if you owned the townhouse less than 2 years.  Similarly, a car accident causing severe disability or being forced to sell a house in divorce may merit an exception.  IRS Publication 523 will provide detailed information on possible exceptions.

Resources

www.irs.gov/taxtopics/tc701

www.irs.gov/forms-pubs/about-publication-523