There is often no tax consequence when you sell your principal residence. If you incur a loss on the sale, you can’t deduct it from income. If you make a profit (capital gain) from the sale, it is often excludable. For the gain on the sale to be excludable, though, you must pass a couple of tests:
You must own the home for at least 2 of the last 5 years (ending on the date of sale) (ownership test).
You must live in the home for at least 2 of the last 5 years (ending on the date of sale) (use test). For sales of residences after December 31, 2008, periods of nonqualified use may reduce the taxpayer’s exclusion amount. A period of nonqualified use is any period during which the taxpayer, spouse, or former spouse does not use the home as a principal residence. See Modification of the Exclusion for more information.
You cannot have used the exclusion for any residence sold during the 2-year period ending on the date of the current sale.
The ownership and use periods don’t have to be continuous. If you can show that you owned and lived in the home for either 24 full months or 730 days during the last 5 years, then you pass the tests.
Short, temporary absences for vacations or other seasonal absences, even if you rent out the home during your absences, are counted as periods of use.
If you and your spouse file a joint return, meet the above tests, and have a gain of $500,000 or less, then the income is tax-free. For other qualifying filers, the gain must be $250,000 or less. If your gain exceeds the exclusion amount for your filing status, then only the excess amount is taxable. For example, if you and your spouse make a profit of $562,000, then only $62,000 is taxable.
You can claim the $500,000 exclusion on a joint return if all of the following are true:
You and your spouse are married and file a joint return for the year.
Either you or your spouse meets the ownership test.
Both spouses meet the use test.
During the two-year period ending on the date of the sale, neither you nor your spouse excluded gain from the sale of another home.
Do not report the sale of your main home on your tax return unless:
You have a gain and you do not qualify to exclude all of it,
You have a gain and choose not to exclude it, or
You have a loss and you received Form 1099-S.
If you have any taxable gain on the sale of your main home that cannot be excluded, report the entire gain on Schedule D (Form 1040).
If you have a loss on the sale of your main home for which you received a Form 1099-S, you must report the loss on Schedule D even though the loss is not deductible.
You can use your HUD-1 settlement statements from both the sale of the residence and the purchase of the residence to help you determine your adjusted basis in the home as well as the amount of gain or loss on the sale. You can also use documentation about any improvements to help you determine your adjusted basis in the home.
An eligible widow or widower can claim the higher $500,000 home sale gain exclusion if the sale occurs no later than 2 years after the date of his or her spouse's death and if all of the exclusion tests listed above are met prior to spouse’s date of death.
A change in living conditions for you or your spouse, co-owner or resident, may result in eligibility for a reduced exclusion rather than no exclusion at all. If the sale of your main home is due to any of the reasons listed below, you may be eligible for a reduced exclusion amount even if you don’t pass the use and ownership tests or have used the exclusion within 2 years of selling your current home:
A relocation because of a change in employment if the new job is at least 50 miles farther from the residence than the previous job and the change of employment occurred during the period that you owned and used the property as your main home.
The sale of the main home is primarily to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or it is to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. Additionally, there is a safe harbor if a doctor recommends a change of residence due to an issue in the previous sentence. A move is not considered to be due to health it the move merely benefits general health and well-being.
Unforeseen circumstances arose. Among other things, these can include involuntary conversions, natural or man-made disasters, employment changes, death, divorce, or multiple births from the same pregnancy.
Periods of nonqualified use occurring after December 31, 2008 will also reduce the amount that may be excluded. Please see Modification of the Exclusion for additional information.
You can’t exclude the gain on the sale of a home if you sold another home at a gain and excluded all or part of it during the two-year period ending on the date of the sale. If you can’t exclude the gain, you must include the entire amount in your taxable income.
If you meet the ownership and use tests, you may be able to exclude gain from the sale of a home that you rented or used for business. In addition, if you use part of your home to conduct business, you don’t need to allocate the gain to the business portion of the home.
A full exclusion applies upon the sale of the residence except for allowed and allowable depreciation taken since May 6, 1997. If you took depreciation deductions because you rented out your home or used it for business, you can’t exclude the part of the gain that is equal to any depreciation deductions that you took for periods after May 6, 1997. If the property is rental property at the time of the sale, you must report the sale on Form 4797, Sales of Business Property.
You may use part of your property as a home and part of it for business or to produce income. Examples of such use are an apartment building in which you live in one unit and rent out the others, or a store building with an upstairs apartment that you live in.
If you sell the entire property, the transaction is considered the sale of 2 properties. You report the business portion on Form 4797 and you report any taxable personal portion on Schedule D. You can exclude the gain only on the portion used as a home. The sales price, expenses of sale, and adjusted basis of the property that you sold must be allocated between the personal portion and the business portion. You must attach a statement to your return showing the total selling price of the property and the method that you used to allocate the amounts between the two forms.
However, if the part of your property used for business or to produce rental income is within your home, such as a home office for a business, you do not need to allocate the gain on the sale between the business part of the property and the part used as a home. You also do not need to report the sale of the business or rental part on Form 4797. However, you cannot exclude the part of the gain equal to any depreciation allowed or allowable after May 6, 1997.
For sales that take place after December 31, 2008, some different rules may apply when determining the amount of gain that is excludable.
Under the new rules, gain on the sale of a principal residence that is otherwise eligible for the $250,000 / $500,000 exclusion may not be excluded to the extent that gain is allocated to a period of “nonqualified use.” A period of nonqualified use is any period during which the taxpayer, spouse, or former spouse does not use the home as a principal residence.
However, a period of nonqualified use does not include:
Any period before January 1, 2009
Any period during the 5-year period that is after the last period of use as a principal residence by the taxpayer or the taxpayer’s spouse
A period of temporary absence of up to 2 years for reasons of health, employment, and certain unforeseen circumstances
Any period (not to exceed 10 years) during which you or your spouse were serving on qualified official extended duty
Example: A married couple buys a vacation home on January 1, 2007, for $400,000. On January 1, 2009, they convert the home to their principal residence and on January 1, 2011, they sell the home for $700,000. Of the $300,000 gain, only $150,000 [$300,000 × (24 months of qualified use ÷ 48 months of total ownership / use)] is eligible for the exclusion. The remaining $150,000 is taxable in the year of sale.
For more information about the sale of home exclusion, see IRS Publication 523: Selling Your Home.