With housing markets across the country booming, selling homes is on a lot of minds. One way to save on the tax consequences of selling a home is the principal residence gain exclusion. This tax benefit allows homeowners to exclude up to $250,000 ($500,000 if married filing jointly) of their gain from the sale of their home from federal taxable income.
To qualify for the gain exclusion, there are a few tests homeowners must pass and should consider before placing their homes on the market.
- The Ownership Test – Within the past five years ending on the sale date, the owner has owned the home more than two years.
- The Use Test – Within the past five years ending on the sale date, the owner has lived in the home as his or her principal residence for at least two years.
Note: The word “principal” is key here. The qualifications for a principal residence include, but are not subject to, the following:
- The home is near the homeowner’s place of employment.
- Family members live in the home.
- The home’s address is used for government documents, bank accounts, mailing address, etc.
The above tests are independent of one another, and the two-year period does not necessarily have to be a continuous two years (i.e., you could live in the house for the first and fourth year and still qualify).
- The Anti-Recycling Rule – This rule is in place to keep homeowners from using the primary residence gain exclusion more than once within a two-year period.
Let’s now review some hypothetical circumstances, keeping in mind that your situation may be more complex.
Owners of Multiple Homes
- Two homes having the same homeowner(s) are sold within the same year. Only the gain that was earned on the principal residence is allowed to be excluded.
- Two homes have the same homeowner(s). Each home has been used as a principal residence for two years within the past five years. No other homes have been sold in the past two years. Therefore, both homes qualify to utilize the gain exclusion. Now, both homes are sold in the same year, and so only one of them will be able to take the gain exclusion. In this case, we recommend using the exclusion on the highest gain.
- For those married filing jointly, only one person needs to pass the ownership test, and both need to pass the use test to qualify for the $500,000 gain exclusion.
- For those married filing separately, both people need to qualify for the ownership and use test. It is important to note that homeowners will not qualify for the $500,000 gain exclusion, but they can individually qualify for the $250,000 gain exclusion for a total of $500,000.
- Surviving spouses (unmarried) – Surviving spouses can claim the $500,000 gain exclusion if the home sells within two years of the spouse’s date of death, and if all other requirements were met immediately before the date of death.
Homeowners that do not pass each test may be able to prorate the exclusion. To qualify for a prorated gain exclusion, homeowners will need to have sold their homes for one of the following reasons:
- The move was related to a change in place of employment for a qualified person.
Note: A qualified person can be the taxpayer, the spouse, any co-owner of the home, or any person whose principal residence is within the taxpayer’s household.
To further qualify under this reason of sale, homeowner(s) will need to pass the distance test—when the new place of employment is at least 50 miles from the former primary residence.
- The owner’s move was related to health reasons for a qualified individual.
To pass this reason of sale, the homeowner(s) will need to obtain proof that the move was to provide medical care for a qualified individual facing a serious illness.
- The move was related to specified unforeseen circumstances.
To qualify under this reasoning, the homeowner(s) could not have reasonably anticipated the occurrence of an event that would cause them to sell their home. Some events that qualify are:
- Natural disasters or acts of war or terrorism resulting in a casualty to the residence.
- Death of a qualified individual.
- A qualified individual has lost his or her job and is unable to pay for the housing costs and reasonable basic living expenses for the household.
- A qualified individual’s divorce or legal separation.
There are many situations in which homeowners can qualify for the primary residence gain exclusion. If you have further questions regarding its use, contact a PYA executive below at (800) 270-9629.