How am I taxed if I sell my principal residence (main home)?

If you have a capital gain from the sale of your principal residence, you may be able to exclude from income up to $250,000 of the gain ($500,000, for certain married taxpayers filing a joint return). The exclusion may be allowed each time you sell or exchange your principal residence, but generally no more frequently than once every two years. A loss on the sale of you principal residence is not deductible.

What is a Principal Residence?

A "principal residence" is the home where you ordinarily lives most of the time. An individual can only have one principal residence at any one time. The home MUST be a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.

Excluding Capital Gain

To exclude* up to $250,000 of capital gain ($500,000, for certain married taxpayers filing a joint return) you MUST meet BOTH the "ownership" and "use" tests. This means during the 5-year period ending on the date of sale, you MUST have:

1. OWNED the home for at least 2 years, AND

2. USED the home as your principal residence for at least 2 years.

NOTE: The required 2 years of ownership and use during the 5-year period ending on the date of the sale do not have to be continuous nor do they have to occur at the same time. You meet the tests if you can show that you owned and lived in the property as your principal residence for either 24 full months or 730 days (365 × 2) during the 5-year period ending on the date of sale.

*If you owned and lived in the property as your principal residence for LESS than 2 years, you may be able to claim a reduced capital gain exclusion (defined below).

Reduced Capital Gain Exclusion

A reduced capital gain exclusion applies to taxpayers who do NOT meet the "ownership and use tests" due to a change in health or place of employment. There is also a provision in the law that a reduced exclusion may apply due to "unforeseen circumstances." The sale of a principal residence will be considered as occurring primarily because of “unforeseen circumstances” if any of the following events occur during the taxpayer’s period of use and ownership of the residence:

• death,
   
• divorce or legal separation,
   
• becoming eligible for unemployment compensation,
   
• a change in employment that leaves the taxpayer unable to pay the mortgage or reasonable basic living expenses,
   
• multiple births resulting from the same pregnancy,
   
• damage to the residence resulting from a natural or man-made disaster, or an act of war or terrorism, or
   
• condemnation, seizure or other involuntary conversion of the property.

Other circumstances may be considered "unforeseen" solely at the discretion of the IRS Commissioner.

Depreciation of the Principal Residence AFTER May 6, 1997

If you were entitled to take depreciation deductions because you used your home for business purposes or as a rental property, you CANNOT exclude the part of the gain equal to any depreciation allowed or allowable AFTER May 6, 1997.

Sale of Principal Residence Acquired in a Like-Kind Exchange

Effective for sales or exchanges after October 22, 2004, the exclusion of gain from the sale of a principal residence is inapplicable to property acquired in a like-kind exchange during the five-year period before the sale. Thus, the exclusion of gain will NOT apply if the principal residence was acquired in a like-kind exchange in which any gain was not recognized within the previous five years.

Reduced Capital Gain Exclusion of Principal Residence for Non-Qualifying Use

Beginning January 1, 2009, taxpayers will not be allowed to exclude any gain attributable to a "nonqualified use." This will prevent taxpayers from selling a second home or vacation home and excluding all the gain even if they meet the two-out-of-five years ownership and use tests.

For purposes of determining the amount of gain that is allocated to periods of nonqualified use, gain will be allocated based on the following ratio:

1. The aggregate periods of nonqualified use during the period the property was owned by the taxpayer.

2. The period the property was owned by the taxpayer.

The amount of gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction (1) the numerator of which is the aggregate periods of nonqualified use during the period the property was owned by the taxpayer, and (2) the denominator of which is the period the taxpayer owned the property.

A period of nonqualified use is any period beginning January 1, 2009, during which the property is NOT used as the principal residence of the taxpayer, the taxpayer's spouse, or former spouse. Since the definition of a period of nonqualified use doesn't include any period before January 1, 2009, a taxpayer can avoid this new rule if he moves into another residence he owns and makes it his principal residence before January 1, 2009. A period of nonqualified use does not include any portion of the five-year testing period which is after the last date that the property is used as the principal residence. Therefore, any period after the last date the property was used as the principal residence (regardless of use during that period) is not taken into account in determining periods of nonqualified use. This new law is effective for sales and exchanges beginning January 1, 2009.

Military Tax Relief Act of 2003 (H.R. 3365) (MFTRA)

This tax act creates a special exception to the "two-out-of-five year rule" for uniformed and foreign service personnel called to active duty away from home. They may elect to suspend the five-year test period. The maximum length of the suspension is 10 years and it may only be made with respect to one property. If the election is made, the five-year period ending on the date of the sale of a principal residence does not include any period up to 10 years during which the serviceman or woman, his or her spouse, is on qualified official extended duty. An election may be revoked at anytime.

This election is available to members of the Armed Forces (Army, Navy, Air Force, Marine Corps, and Coast Guard), Commissioned Corps of the National Oceanic and Atmospheric Administration, Commissioned Corps of the Public Health Service, and the Foreign Service.

"Away from home" is defined as “qualified official extended duty” while serving at a duty station that is at least 50 miles from the taxpayer’s principal residence or while residing in government quarters under government orders. “Extended duty” is any period of active duty pursuant to a call or order to such duty for a period in excess of 90 days or for an indefinite time.

This election is effective for sales made after May 6, 1997.

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