With home prices at record highs in some parts of the country and many people looking to make career or lifestyle changes, you may be considering downsizing or moving to another location. If so, you could be in line for a large tax break when you sell your home. In fact, you might be able to pocket up to a half million dollars in gain from the sale of your principal residence without owing any federal income tax.

Under federal tax law, you may be able to exclude from tax up to $250,000 of gain — $500,000 if you’re married filing jointly — on the sale of your home. To qualify, you must have owned and used the home as your principal residence for at least two of the five years prior to the sale. 

There’s no definitive definition of “principal residence” in the tax code. Generally, your principal residence is the place where you hang your hat most of the time and where you’ve established legal residency for other purposes. It doesn’t have to be a house or condominium — a trailer or a boat may even qualify — but the exclusion can’t be claimed for a second home. This may change your living habits.

For instance, if you spend seven months at a winter home in a warm climate and five months at a summer home, the winter home is considered to be your principal residence. So if you want to sell your summer home, you may first want to spend enough additional time there that it can qualify as your principal residence.

Here are several other key points about the home sale gain exclusion: 

• Under the two-out-of-five-year rule, the years don’t have to be consecutive. Furthermore, you can meet the use and ownership requirements in different tax years.
• If you file a joint return, the maximum exclusion is available if 1) either spouse meets the ownership test, 2) each spouse meets the use test, and 3) neither spouse has elected the exclusion within the last two years. This is particularly significant if you’ve recently divorced or remarried.
• To meet the use test, you must physically occupy the home, but short absences don’t count against you. Conversely, a longer absence, such as a one-year sabbatical by a college professor, doesn’t contribute to the time the home is used as your principal residence.
• If the home has been used for business rental or use — including use of a home office for which you’ve claimed a tax deduction — you must recapture depreciation deductions attributable to the period after May 6, 1997. The recaptured income is taxable at a maximum rate of 25%.

The exclusion isn’t allowed if you sold another qualified principal residence within the last two years. Finally, you may qualify for a partial home sale gain exclusion under certain conditions.

Even if you don’t meet the two-out-of-five-year rule, you may be eligible for a partial exclusion if you sell the home due to certain unforeseen circumstances including:

• Death,
• Divorce,
• Loss of employment,
• Job change reducing ability to pay for the home,
• Multiple births from the same pregnancy,
• Damage from a disaster, and
• Taking of property.

If none of these exceptions apply, the IRS will examine the facts and circumstances of the case. The partial exclusion is equal to the available exclusion amount ($250,000 or $500,000, depending on your filing status) multiplied by the percentage of time for which you met the requirements.

Example: You and your spouse have owned and used a home as your principal residence for the last nine months. Due to a debilitating illness, you’re forced to move, so you sell the home at a $200,000 gain. In this scenario, you may salvage a partial exclusion. 

The applicable percentage is 37.5% (9 months divided by 24 months). When you multiply $500,000 by 37.5%, you arrive at $187,500. Accordingly, you can exclude from tax $187,500 of the gain. Only the remaining $12,500 is taxable as a capital gain.

Short-term capital gains are taxable at ordinary income rates topping out at 37%. But the long-term capital gains rate, which applies to gain on a home owned longer than one year, is generally 15% or 20%, depending on your annual income. 

The home sale gain exclusion can be worth some effort to ensure you meet the requirements. If you have any questions regarding whether your circumstances will enable you to benefit from this tax break, don’t hesitate to contact us.

The amount of gain from a home sale is the difference between the sales price and your adjusted basis. Typically, your adjusted basis is the amount paid for the home plus the cost of any home improvements. Therefore, it’s especially important to keep detailed records of improvements that could increase your basis.

For example, say that you’re a single filer who purchased your principal residence for $500,000. In the last five years, you’ve spent $100,000 remodeling your kitchen and bathrooms. Now you’re selling the home for $800,000. With the $100,000 increase to your basis, your gain is $200,000 ($800,000 - $600,000) rather than $300,000 ($800,000 - $500,000). Assuming that you otherwise qualify, your entire gain is excluded from tax.