With residential real estate markets surging, significant unrealized gains are piling up for many homeowners. If you are thinking about selling your principal residence, you may be wondering about the tax implications. The good news is that tax laws allow you to exclude a home sale gain of up to $250,000 for unmarried taxpayers and up to $500,000 for married taxpayers.

Gain Exclusion Basics

Ownership and Use Tests – To take full advantage of the principal residence gain exclusion, you must pass two tests: the ownership test and the use test. Note that the two tests are completely independent, meaning that the periods of ownership and use need not overlap.

  • Ownership Test: You must have owned the home for at least two years out of the five-year period ending on the sale date. 
  • Use Test: You must have used the home as your principal residence for at least two years out of the five-year period ending on the sale date. You can pass this test by living in the house for 730 days combined out of a five-year period. The days do not need to be consecutive.

What Counts as a Principal Residence?

IRS regulations say you must evaluate all the facts and circumstances to determine whether or not a property is your principal residence for gain exclusion purposes. If you occupy more than one residence during the same year, the general rule is that the principal residence for that particular year is the one where you spent the majority of time during the year. Other relevant factors can include:

  • Where you work
  • Where family members live
  • The address used on your income tax return, driver’s license, auto registration, and voter registration
  • Mailing address for bills and correspondence

Special Considerations if You are Married

  • If you are married and file separately, you and your spouse can potentially qualify for two separate $250,000 exclusions.
  • If you are married and file jointly, you qualify for the $500,000 exclusion if
    • Either you or your spouse pass the ownership test for the property and
    • Both you and your spouse pass the use test
  • If you are married and file jointly, it is possible for both you and your spouse to individually pass the ownership and use tests for two separate residences. In this case, you and your spouse would qualify for two separate $250,000 exclusions.

Special Rule for Unmarried Surviving Spouses – An unmarried surviving spouse can claim the larger $500,000 exclusion for sale of a principal residence that occurs within two years after the spouse’s death, assuming all other requirements were met immediately before the spouse died.

Anti-Recycling Rule – The exclusion is generally available only when you have not excluded an earlier gain within the two-year period ending on the date of the later sale. In other words, you generally cannot recycle the gain exclusion privilege until two years have passed since you last used it. You can claim the larger $500,000 joint-filer exclusion only if neither you nor your spouse have used the exclusion on an earlier sale within the two-year period. If one spouse claimed the exclusion within the two-year window, but the other did not, the exclusion is limited to $250,000.

When to “Elect Out” of the Gain Exclusion Privilege – You always have the option to “elect out” of the gain exclusion and report the sale profit as a taxable gain. You can retroactively elect out by amending a previously filed return within the three-year period beginning with the filing deadline for the year-of-sale return. This may be beneficial when you have two principal residence sales within a two-year period, with the later sale producing a larger gain.

Prorated Gain Exclusion

What happens if you sell your home for a large profit after living there for only 18 months instead of the required two years? Or what if you sell your home less than two years after excluding a gain from the sale of a previous residence? The good news is that the IRS allows a prorated (reduced) gain exclusion in certain circumstances when the ownership and use tests or anti-recycling rules discussed above are not met. The prorated exclusion may be large enough to shelter the entire gain. The prorated gain exclusion only applies when the premature sale is due primarily to one of the following reasons:

  • A change in place of employment – A premature sale is automatically considered to be primarily due to a change in place of employment if the distance between the new place of employment and the former residence is at least 50 miles more than the distance between the former place of employment and the former residence.
    • Note that if you are self-employed and work out of your home, you pass this test if you purchase a new home at least 50 miles from your old home.
    • If you can’t pass the 50-mile automatic rule, you can still pass this test by obtaining documentation showing the premature sale was primarily due to your change in place of employment, assuming the facts so indicate.
  • Health reasons – You pass this test if your move is to
    • Obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or
    • Obtain or provide medical or personal care for a qualified individual who suffers from a disease, an illness, or an injury
  • Specified unforeseen circumstances – A premature sale is generally considered to be due to unforeseen circumstances if the primary reason for the sale is the occurrence of an event that you could not have reasonably anticipated. Under the safe-harbor rule, a premature sale is deemed to be due to unforeseen circumstances if any of the following events occur:
    • Involuntary conversion of the residence
    • A natural or man-made disaster or acts of war or terrorism resulting in a casualty to the residence
    • Death of a qualified individual
    • A qualified individual’s cessation of employment, making him or her eligible for unemployment compensation
    • A qualified individual’s change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household
    • A qualified individual’s divorce or legal separation under a decree of divorce or separate maintenance
    • Multiple births resulting from a single pregnancy of a qualified individual

As you can see, there is much to know about the principal residence gain exclusion. If you are considering selling your principal residence and have questions regarding the tax implications, consult your KTLLP advisor to discuss your unique situation.