If you are selling your primary residence for a sizable profit, excluding real estate gains from federal income tax can be one of the most valuable tax breaks. You can potentially exclude (pay no federal income tax) up to $ 250,000 from the profits from the sale of a home or up to $ 500,000 if you are a married spouse filer. Good.
Here’s the second installment in our two-part series on how to enjoy it. For part 1, see this previous Tax Guy.
Singles can exclude gains from the sale of a home up to $ 250,000 and married couples filing jointly can exclude up to $ 500,000. However, you must pass the following tests to be eligible.
You must have owned the property for at least two years during the five-year period ending on the date of the sale. Two years means periods totaling 24 months or 730 days.
You must have used the property as your primary residence for at least two years within the same five-year period.
The periods of ownership and use do not necessarily have to overlap. For example, you could rent a house and use it as your primary residence during years 1 and 2, then buy it and rent it to others during years 3 and 4. If you sold the house during years 1 and 2, Year 5, you would pass both the ownership and use tests and qualify for the gain exclusion privilege.
To qualify for the larger $ 500,000 joint filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.
If you have excluded a prior gain during the two year period ending on the date of a subsequent sale, you are not eligible for the exclusion of gain clause for the subsequent sale. In other words, the winnings exclusion privilege cannot be “recycled” until two years have passed since you last used it.
Common depositors with a house
To be eligible for the $ 500,000 earning exclusion for joint filers, at least one of the spouses must pass the property test and both spouses must pass the use test. When only one spouse passes both tests, the maximum gain exclusion is only $ 250,000. However, if you and your spouse own two homes, you can potentially separate each of the $ 250,000 exclusions.
Example 1: Suppose you get married and immediately sell your valuable house, which you owned and used as your primary residence for many years, for a whopping gain of $ 600,000. You then file a joint return for the year of the sale with your new spouse. Unfortunately, you are not eligible for the larger $ 500,000 joint filer exclusion because your spouse does not pass the use test. Therefore, you must report a taxable gain of $ 350,000 (profit of $ 600,000 – exclusion of $ 250,000) on your return for the year of the sale. Ouch.
Tax saving strategy: Instead of selling immediately, you and your new spouse should consider living in your home for at least two years after marriage. This way you will be eligible for the largest depositor of $ 500,000 as you will pass the ownership test and you and your spouse will pass the use test.
Common depositors with two houses
If you own two homes and you are filing jointly, each spouse’s eligibility excluding the $ 250,000 is determined separately, and each spouse is considered to own each property for any period during which the property is actually owned. ‘one or the other of the spouses. Actual ownership doesn’t matter as long as you jointly file.
Example 2: You and your spouse have a suburban marriage and own two houses. You work in LA and most of the time live in a condo there. Your spouse works in Washington and lives there most of the time in a townhouse. The larger joint filer exclusion of $ 500,000 is not available for any of the homes because you and your spouse must pass the use test to be eligible for the larger exclusion. However, two separate exclusions of $ 250,000 are potentially available in this situation. Here is how it would work.
Suppose both houses have been owned for more than a few years. As long as you are jointly filing in the year a home is sold, the ownership test will pass for that home, whether the home is owned jointly or separately. This is because, as stated earlier, each spouse is considered the owner of a property for any period in which the property actually belongs to either spouse. So if you sell the LA home, you pass both the home ownership test and that property test. If the DC home is sold, your spouse will pass both tests for that property.
So, on a joint return, you would be entitled to an exclusion of $ 250,000 if you sold the LA home. Your spouse would be eligible for a separate exclusion of $ 250,000 if the DC home is sold. This would be true whether you were selling both houses in the same year or in separate years.
Married but filing separate returns
If you and your spouse file separate returns it gets more complicated, but you may still be eligible for two separate exclusions of $ 250,000. In the separate return scenario, beneficial ownership is important.
If you and your spouse jointly own a property and both live there, you can potentially exclude up to $ 250,000 from your share of the gain on your separate return if the property is sold. Your spouse can do the same.
If you and your spouse own two properties separately and live there separately, you can potentially exclude up to $ 250,000 from the gain on the sale of your property. Your spouse can do the same when selling their property.
If your spouse is deceased and you have not remarried, you cannot file a joint return for a year after the year of your spouse’s death. Not so long ago, this little rule could have prevented you from taking advantage of the larger exclusion of $ 500,000 that is allowed for joint filers because you would have been limited to the smaller exclusion of $ 250,000. for sole filer if you had sold your house within a year of the year of your spouse’s death. Our beloved Congress has addressed this problem but has not completely cured it.
Under today’s rules, an unmarried surviving spouse can claim the highest $ 500,000 gain exclusion for a sale of principal residence that occurs within two years of the date of the spouse’s death, assuming all other requirements for the $ 500,000 exclusion have been met immediately prior to the death of the spouse. Note: since the two-year eligibility period with the widest exclusion begins on the date of the spouse’s death, a sale that takes place in the second calendar year following the year of death but more than 24 months after the date death will not be eligible for the most significant $ 500,000 earnings exclusion. You have to find the right timing to qualify.
Reduced gain exclusion when you violate all timing rules
What happens when you do not follow all of the above qualifying rules? For example, you could sell your house for a good profit after living there for only 18 months instead of the required two years. Or you could sell your current home within two years of ruling out the gain from the sale of a previous home. Do you have to pay tax on the entire gain when you make such a “premature” sale? Not necessarily. IRS regulations allow you to request a reduced exclusion (a fraction of the total amount of $ 250,000 or $ 500,000) in many circumstances.
The reduced exclusion is equal to the total exclusion of $ 250,000 for a single filer or $ 500,000 for joint filers (as the case may be) multiplied by a fraction. The numerator is the shorter of the following: (1) the total period during which the property is owned and used as a principal residence during the five-year period ending on the date of sale or (2) the period between the last sale for which you requested an exclusion and the sale date of the house currently being sold. The denominator is two years (12 months or 730 days). It sounds more complicated than it actually is. Here are some illuminating examples.
Example 3: You and your spouse are filing jointly. Due to a job change that required a long-distance move, you sold your home, which you had owned and used as your primary residence for 11 months. Because you bought at exactly the right time, you got a payout of $ 200,000. You are entitled to a reduced earnings exclusion of $ 229,167 ($ 500,000 x 11/24). Thus, you can exclude the entire gain for federal income tax purposes.
Example 4: You sold your old home 15 months ago and claimed the earnings exclusion privilege. For health reasons, you are now about to complete the sale of your current home, which you have owned and used as your primary residence for 15 months, for a gain of $ 125,000. You are entitled to a reduced earnings exclusion of $ 156,250 ($ 250,000 x 15/24). Thus, you can exclude the entire gain for federal income tax purposes.
Eligibility for reduced exclusion
The reduced exclusion offer is only available when you sell your home due to:
* A change of workplace.
* Health reasons.
* Other unforeseen circumstances, as specified by the IRS.
For more details on eligibility for reduced exclusion, see IRS Publication 523 (Selling Your Home) at www.irs.gov.
The bottom line
Like I said at the start, the real estate gains exclusion clause can be one of the best tax saving deals you’ll ever have. And you can qualify under certain circumstances that might surprise you.