Capital Gains Exclusions When You Sell Your Home

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Capital Gains Exclusions

There is still confusion out there about capital gains exposure when you sell your home. It used to be that you could defer any capital gain on your principal residence sale as long as you replaced it within two years. Thanks to 1997 legislation, that all changed. No replacement residence is required now. All capital gain is now subject to tax, but there is an exclusion that helps reduce the pain.

As for the capital gains exclusions mentioned above, they apply to one sale or exchange every two years. And the home is not required to be the principal residence at the time of purchase or sale, but it must meet ownership and use tests: you must have owned the residence as a principal residence for a total of at least two of the five years before the sale or exchange, and you must have occupied the residence for a total of at least two of the five years before the sale or exchange.

For married folks, filing a joint tax return will qualify for the $500,000 exclusion on the joint return provided either spouse meets the ownership test, both spouses meet the use test and neither spouse is ineligible for exclusion because he or she made a sale of exchange of a residence within the last two years. For those marrieds who don’t qualify for the $500,000 exclusion, they may still use the $250,000 exclusion, or a prorated exclusion, if either spouse meets the ownership and use requirements. 

Widowed spouses selling a residence generally are only eligible for the $250,000 exclusion on their tax returns filed as a single person, surviving spouse, or head of household. However, they may be eligible for the $500,000 exclusion if the residence is sold during the year of the death of spouse, provided the sale is reported on a final joint return.

If a taxpayer doesn’t meet the ownership or residence requirements, a pro-rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. The amount of the available exclusion is equal to $250,000 or $500,000 multiplied by a fraction equal to the shorter of the number of months of the total of periods during which the ownership and use requirements were met during the five-year period ending on the date of sale, or the period after the date of the most recent sale or exchange to which the exclusion applied divided by 24 months.

A more recent wrinkle involves those with a capital gain after the exclusion who have an adjusted gross income over $200,000. That gain may be subject to the Net Investment Income Tax of 3.8% enacted in the Affordable Care Act (Obamacare).