When selling their home, one of the most common questions people ask is: “Am I going to pay taxes?”
This post will help you identify situations when you’ll probably avoid taxes and when you might have to pay taxes. Disclaimer: This is intended for educational purposes, not to provide specific advice. For tax advice regarding your specific situation, please consult a tax professional.
How to know if you'll pay taxes when it comes time to sell your home? Take a look at the following information.
Section 121 Tax Exclusion
In order to encourage people to buy homes, Congress created a special rule in the tax code. Section 121 (Exclusion of gain of principal residence) allows for homeowners to exclude some or all of the capital gain from the sale of their primary residence, as long as they meet certain criteria. These criteria are called the ownership and use tests, discussed below.
How much can I exclude?
Generally, a single homeowner can exclude up to $250,000 in capital gains, while a married couple filing jointly can exclude up to $500,000. Any gains above this limit are taxed at long-term capital gains rates. If this is a concern, you definitely will want to consult a tax professional to ensure that you’re using proper calculations.
What are the ownership and use tests?
These tests are intended to ensure that actual homeowners, and not real estate investors, are taking advantage of this tax incentive. Let’s look at each requirement:
- Ownership test. If you have owned the home for at least 24 months of the previous 60 months (2 of 5 years), you meet the requirements of the ownership test. For a married couple, only one of the two spouses has to meet this criteria. For example, a newly married couple would meet this requirement if one of the spouses previously owned this house, even if the other did not.
- Use test. If you have lived in the home for at least 24 of the previous 60 months, you meet the use test. However, there are a couple of things worth highlighting:
- Each spouse must qualify. Unlike the ownership test, each spouse has to individually meet the use test. Using the previous example, if only one spouse lived in the house for 24 months, then they would not be eligible for the full exclusion until the other spouse meets the criteria.
- This is a day-for-day test. In other words, the IRS considers 24 months to be at least 730 days. 729 days does not count.
- It does not have to be 24 consecutive months. This is an important distinction for military families. For example, let’s assume our married couple has lived in the house for a year, performs a PCS move, then moves back for another year. As long as they meet the 730 day total requirement within a five-year period, they fulfill the use test.
- Lookback period. Assuming you meet both the ownership & use test, there is a lookback period of two years. In other words, if you’ve previously sold a home and used this exclusion within two years, the IRS will not allow you to do it again.
As long as a person (or married couple) meets the ownership and use criteria, and has not sold another home during the previous two years of sale, they qualify for the full exclusion.
What if I don’t think I meet the criteria?
Even in cases where you don’t fully pass the ownership and use tests, you may qualify for a partial exclusion. IRS Publication 523, “Selling Your Home,” contains more information on determining whether you are eligible for a partial exclusion.
What about special circumstances?
“Selling Your Home” also addresses certain special circumstances. Some examples include:
- Special considerations for recent widows and widowers.
- Rules regarding separated or divorced taxpayers.
- Rules about vacant land treatment.
- Service, Intelligence, and Peace Corps personnel. This section is probably the most important for military families.
How does this affect military families?
This section addresses the impact of our military lifestyle on home ownership. Specifically, it allows certain flexibility in the ‘2 of 5 year requirement’ for the use rules, based upon qualified extended duty. You may qualify if you or your service member spouse:
- Are called or ordered to active duty for an indefinite period, or for a definite period of more than 90 days.
- You are serving at a duty station at least 50 miles from your main home, or you are living in government quarters under government orders.
- You are a military member (this also applies to certain non-military personnel).
If you meet these criteria, you MAY be able to suspend the use test for up to 10 years. For example, an Army major who lived in a home from 2010-2013 who then received orders to relocate overseas for the next five years could still qualify for the exclusion. However, since each situation is different, it’s important to consult a tax professional to determine how these rules apply to you.
Conclusion
When selling your home, it’s important to be aware of the capital gains exclusions. For many military families, the answer might be pretty simple. However, just knowing what you might be eligible for will help you be more knowledgeable. If you have any questions, it is best to consult with a tax professional to determine if you’ll owe taxes, and how much.
Author bio: Forrest Baumhover retired from a 24-year Navy career to start his own fee-only financial planning firm, Westchase Financial Planning, in Tampa, Florida. In addition to helping clients, Forrest enjoys writing educational articles on a variety of financial topics. Forrest is a Certified Financial Planner™ professional and is an enrolled agent.
