Selling a Primary Residence
The sale of a principal residence is generally not a taxable event, unless the taxpayer:
- Has a gain and does not qualify to exclude it all
- Has a gain and elects not to exclude it
- Received a Form 1099-S for the sale
Typically, a single taxpayer can exclude from their income up to $250,000 of gain from the sale of a personal residence if the following criteria are met (Internal Revenue Code [IRC] Sec. 121):
- Ownership and use: the individual must have owned and used the home as a principal residence for at least two out of the five years prior to the sale (the two years do not have to be consecutive).
- Frequency limitation: The exclusion applies to only one sale every two years.
Married couples filing a joint return can exclude up to $500,000 of gain under the following conditions:
- Ownership: either or both spouse(s) must have owned the residence for at least two out of the five years prior to the sale.
- Use: both spouses must have used the residence as their principal residence for at least two out of the five years prior to the sale.
- Frequency limitation: during the two-year period ending on the date of the sale, neither spouse excluded gain from the sale of another home.
Use and frequency conditions
It is worth noting that the use and frequency tests must be met by both spouses in order for them to qualify for the full $500,000 exclusion, while only one of the two must meet the ownership test. If both spouses do not meet the use and frequency tests, the allowable exclusion is limited to the sum of the amounts that each spouse would be qualified to exclude if they had not been married. Each spouse is treated as owning the property for the period of time that either spouse owned the property.
For example, consider the following case: On January 1, 2010, Cindy purchased a home for $250,000. On September 10, 2012, Cindy and George were married. On January 1, 2013, they decided to sell their home for $600,000. In this instance, because George does not meet the use test, only Cindy can exclude $250,000 of gain. The additional $100,000 will be taxable.
If we change the scenario so that the house was instead sold on September 12, 2014, then they would meet all the requirements to exclude the entire gain.
If each spouse sells a home prior to marriage and each spouse meets the ownership, use, and frequency tests, then each spouse may exclude up to $250,000 of gain on his/her own home.
For example, Cindy and George both sold homes in 2019, prior to their marriage and purchase of their new home. They had both owned and lived in their respective homes for more than two out of the last five years. Neither Cindy nor George had excluded a principal residence gain in the prior two years. As long as the gain on the sale of each of their individual residences was below $250,000, there would be no taxable event. If, however, Cindy had a gain of $300,000 and George had a gain of $150,000, George would not be allowed to exclude the $50,000 excess gain from Cindy’s sale of a personal residence.
The $500,000 gain exclusion amount that applies to taxpayers filing a joint return will also apply to unmarried surviving spouses if the sale occurs within two years of the death of their spouse. To qualify for this, each of the following conditions must be met (IRC Sec. 121[b]):
- Either the surviving spouse or the deceased spouse must meet the two-year ownership requirement for the residence immediately before the spouse dies.
- Both spouses must meet the two-year use requirement immediately before the spouse dies.
- Neither of the spouses may have used the exclusion during the past two years.
Note that this rule will not apply if the surviving spouse remarries before a sale or exchange of the residence within the two-year period.
Reduced exclusion rules
Taxpayers who do not meet the two-year ownership and use tests or who use the Section 121 exclusion more than once in a two-year period may qualify for a reduced exclusion. A reduced exclusion is available if the primary reason the taxpayer sold a primary residence was one of the following:
- A change in place of employment
- Unforeseen circumstances
These reduced exclusion rules will next be described in greater detail.
Change in place of employment
A reduced exclusion will apply if the taxpayer’s primary reason for the sale is a change in the location of a qualified individual’s employment. “Qualified individuals” are defined as the following:
- The taxpayer or taxpayer’s spouse
- A co-owner of the home
- A person whose main home is the same as the taxpayer’s
“Employment” includes the state of work with a new employer or a new location of the same employer. It also includes the start or continuation of self-employment.
A change in place of employment is considered to be the primary reason the taxpayer sold the home if both of the following are true:
- The change occurred during the period the taxpayer owned and used the property as a main home.
- The new place of employment is at least 50 miles farther from the taxpayer’s home than was the former place of employment. If there was no former place of employment, the new place of employment must be at least 50 miles from the home sold.
The sale is due to health if the primary reason for the sale is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of a disease, illness, or injury of a qualified individual. The sale of a home is not because of health if the sale merely benefits a qualified individual’s general health or well-being.
Here, qualified individuals include, in addition to the individuals listed in the section above, any of the following:
- Parent, grandparent, stepmother, or stepfather
- Child, grandchild, stepchild, or adopted child
- Brother, sister, stepbrother, stepsister, half-brother, or half-sister
- Mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, or daughter-in-law
- Uncle, aunt, nephew, niece, or cousin
Reduced exclusion rules apply if the primary reason for the sale is the occurrence of an event the taxpayer did not anticipate before purchasing and occupying the residence. A taxpayer does not qualify for a reduced exclusion if the primary reason for the sale is a preference for a different home or an improvement in financial circumstances.
The following events qualify as unforeseen circumstances:
- An involuntary conversion of the home
- Natural or man-made disasters or acts of war or terrorism resulting in a casualty to the home
- Any of the following, applying to qualified individuals (as defined under “Change in place of employment”):
- Loss of job resulting in being eligible for unemployment compensation
- A change in employment or self-employment status that results in the taxpayer’s inability to pay reasonable basic living expenses
- Divorce or legal separation
- Multiple births resulting from the same pregnancy event the Internal Revenue Service (IRS) determines to be an unforeseen circumstance
Converting a Principal Residence to Rental Use
Homeowners may still qualify for gain exclusion under IRC Section 121 even if the home is converted to rental use.
If the rental portion of the taxpayer’s home was used as a personal residence for two or more of the five years before the sale, the taxpayer can exclude the gain on the entire home (except for any depreciation allowed or allowable after May 6, 1997).
For example, Susan purchased her home in April 2010 and used the entire home as her principal residence. In May 2018, Susan moved out but was not able to sell the residence right away. Susan decided to rent the home until she could sell it. Susan eventually sold the home in January 2019. Because Susan owned and used the home as a principal residence for at least two out of the five years before the sale, she would be able to exclude up to $250,000 of gain on the sale. However, she would not be able to exclude the part of the gain equal to the depreciation allowed while renting the house.