The prime residential real estate selling season is in full swing — and 2017 might be a good time to sell, depending on your situation.
So, while prospective sellers are making their properties look like model homes in the hopes of raking in a nice profit, this is a good time to review how taxes will factor into the transaction. With the home sale gain exclusion tax break, the profit from selling your principal residence might be free from federal income taxes (and possibly state income taxes, too). The rules are straightforward for most sellers.
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An unmarried homeowner can potentially sell a principal residence for a gain of up to $250,000 without owing any federal income tax. If you’re married and file jointly, you can potentially pay no tax on up to $500,000 of gain. To qualify, however, you generally must pass two tests.
Ownership Test. You must have owned the property for at least two years during the five‑year period ending on the sale date.
Use Test. You must have used the property as a principal residence for at least two years during the same five‑year period (periods of ownership and use need not overlap).
To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
If you excluded a gain from an earlier principal residence sale under these rules, you generally must wait at least two years before taking advantage of the gain exclusion break again. If you’re a joint filer, the $500,000 exclusion is only available when neither you nor your spouse claimed an exclusion for an earlier sale within two years of the sale date in question.
Tip: If you make a “premature” sale that fails to meet the preceding timing rules, don’t give up hope. You may qualify for a reduced exclusion that will be large enough to shelter your entire gain from federal income tax as described below.
Reduced Exclusion May Apply to “Premature” Sales
You generally cannot claim the federal home sale gain exclusion break if you fail either the ownership test or the use test explained in this article. Also, you generally cannot claim an exclusion for a sale that occurs less than two years after an earlier sale for which you claimed an exclusion.
The key word here is generally, because there’s a favorable exception that might help when you make a “premature” sale that fails to meet the basic timing rules. Specifically, you can claim a reduced exclusion if your premature sale is primarily due to:
1. A change in place of employment.
2. Health reasons.
3. Certain unforeseen circumstances outlined in IRS regulations.
For example, let’s say you and your spouse own and use a home as your principal residence for 18 months. You are forced to sell because your job is transferred to a distant state. Under these circumstances, you would qualify for a reduced gain exclusion of $375,000. This is 75% of the full $500,000 joint-filer exclusion, because you owned and lived in the home for 75% of the required two-year period.
Bottom Line: If you qualify for the reduced exclusion, it can be generous enough to completely shelter your profit from federal income tax.
In most cases, the federal home sale gain exclusion rules are generous and fairly simple. However, as with all tax breaks, things can get complicated if your situation is the least bit out of the ordinary. For example, if you engaged in a tax-free rollover under the old law rules, there are other rules that apply. Your tax adviser can tell you if your home sale transaction will be free from federal income tax and help you plan for the best tax results.