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How to Claim the Capital Gains Exemption When You Sell Your Primary Residence

Table of Contents
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    Key Takeaways:

    • Selling a home can have tax consequences
    • Certain situations can exempt you from the capital gains tax
    • A tax professional can help make sure you aren’t overpaying taxes

    Homeownership is an exciting part of anyone’s financial journey. It is worth keeping in mind that you must report any proceeds you earn from the sale of a capital asset, like your primary residence, on your income tax return. You also must pay capital gains tax as required. Your home is a capital asset, but luckily, you don’t necessarily have to pay capital gains taxes when you sell it. 

    The Internal Revenue Service (IRS) has special rules that allow you to exempt a certain amount of gains when you sell your primary residence. This can save you a lot of money, but only if you understand the rules. 

    This guide to taxation on the sale of your primary residence explains what to expect from a tax perspective when you sell your home. It also outlines the criteria you need to meet for your property to qualify as a primary residence. Finally, it looks at mistakes to avoid when selling your home. Here’s what you need to know if you don’t want a big tax bill when you sell your home. 

    Taxation on the Sale of Your Primary Residence

    The amount you earn on the sale of your home may be subject to capital gains tax. Capital gains taxes, however, don’t apply to the sale price of your home. They only apply to the proceeds from the sale, and you can exempt a certain amount. Here is how to calculate the amount of your gain when you sell a home. 

    1. Determine the Basis for Your Primary Residence

    The basis of any capital asset, including your home, is the amount you paid for the asset. Say you bought stocks for $50,000. This is their basis, and you subtract this amount from the sale price to calculate your gain when you sell the stocks. You can also count expenses you incurred to buy the asset in its basis. This includes real estate commissions, title insurance, and similar costs. 

    You can also add capital repairs to the basis. Say you spent $20,000 on a new roof, $10,000 upgrading HVAC equipment, and $15,000 on rewiring the home. All of these expenses increase your basis. You can’t, however, count routine maintenance or repairs. Fixing a broken window, paying a lawn service to move the yard, or servicing your furnace doesn’t count as a capital expense. You can’t add these amounts to your basis. 

    2. Calculate Capital Gains on the Sale of a Primary Residence

    A capital gain refers to the difference between the sale price of a capital asset and your basis. Say you sell your home for $500,000 and its basis is $300,000. You have a capital gain of $200,000. This amount is subject to capital gains tax unless you qualify for the exemption. 

    3. Claim the Capital Gains Exemption for Home Sales

    You may be able to claim a capital gains exemption when you sell your home. The exemption is $250,000 for people who file as single or as married filing jointly. It is $500,000 for couples who file jointly and widowers who meet the requirements outlined below. You take the exemption and subtract it from your gain. The remaining amount is subject to capital gains tax.

    You don’t have to report the sale of your home on your tax return if you qualify to claim the exemption. You must, however, report the sale if you don’t qualify for the exemption or if you don’t want to claim the exemption for some reason. Your accountant can help you decide the best path forward. 

    How to Prove Primary Residence for Tax Purposes

    The capital gains exemption on primary home sales is for hundreds of thousands of dollars. This means the IRS forfeits tens of thousands in potential tax revenue when it extends this deduction to homeowners. The IRS doesn’t hand out these savings lightly. The agency has rigorous qualification criteria you have to meet to claim the capital gains exemption. Here is an overview of the requirements. 

    1. Automatic Disqualification Terms

    Two things can automatically disqualify you from taking the exemption on a primary residence. The first is if you acquired the property through a 1031 exchange during the past five years. A 1031 exchange is when you sell a property but you invest in a substantially similar property right away to avoid the capital gains tax. 

    You are also automatically disqualified if you are subject to the expatriate tax. You must pay an expatriate tax when you move out of the country.

    2. Ownership and Residency Requirements 

    You must have owned the house for at least 24 months of the last five years. Only one spouse must have owned the home for this time period if you file as married filing jointly. You also must have resided in the home for at least 24 months in the last five years. Both people in a marriage must meet this requirement to claim the full exemption. 

    Vacations and short absences count as living in the home. This is true even if you rented out the home while you were away. You can’t, however, count long periods away when establishing how long you lived in the home unless you were living in a facility because you were mentally or physically unable to care for yourself. People in this situation must have lived in the residence for at least 12 months of the five years leading up to the sale, and as long as you meet that requirement, you can count the days you lived in a care facility as if you were living in your home. 

    3. Look-Back Period

    You can only claim a capital gains exemption once during a two-year period. This is called the look-back requirement. You meet this requirement if you haven’t sold a home in the last two years, and if you have sold a home, you can only meet the look-back requirement if you didn’t claim the exemption on it. 

    4. Exceptions for Divorced or Separated Couples

    An individual who got divorced or separated before selling their home can count it as a residence as long as they are the sole owner and their spouse or former spouse is allowed to live in the home. 

    Different rules apply when the other spouse is not allowed to live in the home. You must meet the residence requirement on your own in this situation, but you can count any time you owned the home on your own or with your spouse when assessing if you meet the ownership requirement. You can count the time your spouse owned the home as if you owned it in cases where the home was transferred to you by your spouse or former spouse. 

    5. Exceptions for Widows

    Widows can claim a $250,000 exemption just like a single person, but they can claim the full $500,000 deduction for married couples if they meet the following requirements:

    • They sell within two years of their spouse’s death
    • They aren’t remarried at the time of the sale
    • They and/or their late spouse haven’t claimed this exemption in the last two years 
    • They meet the residence and ownership requirements on their own or by taking into account their late spouse’s time with the home

    Widows can rely on their late spouses to meet the residency and ownership requirements as long as they haven’t remarried by the time they sell the home. It doesn’t matter if you lived in or owned the home or if your late spouse owned or lived in it on their own. 

    6. Exceptions for Qualifying People on Extended Duty

    Members of the Uniformed Services or the Foreign Service, U.S. intelligence employees, and people in the Peace Corps can extend the five-year test period when they are on qualified extended duty. These taxpayers can add up to 10 years of qualified extended duty to their timelines. 

    This means if someone was on qualified extended duty for eight years, they only need to have lived in the home for at least 24 months of the last 13 years. You simply add the time of your qualified extended duty to the 5-year period, but you can’t go over 15 years. 

    7. Special Rules for Vacant Land Next to Your Home

    Some taxpayers sell their homes as well as vacant land next to their homes. You can claim the exemption on the proceeds from the vacant land sale as long as both sales meet the eligibility criteria outlined above, the sales happen within two years of each other, and you used the vacant land as part of your home. You must treat these two sales as a single transaction and report them together. You can’t claim the exemption twice. 

    8. Destroyed or Condemned Homes

    The IRS also has special rules for taxpayers who lived in a destroyed or condemned home prior to living in the home they are now selling. You can count the time in the destroyed home when determining if you meet the ownership and residency requirements. 

    Here is an example. Imagine you lived in a home for five years. It was destroyed in a fire. You bought a different home, and after living there for one year, you decide to sell it. You can count the five years you lived in and owned the other home to meet the requirements for the exemption. 

    9. Partial Exemption on Primary Residence Sales

    Taxpayers who don’t qualify for a full exemption on the sale of their home can qualify for a partial exemption. You may qualify for a partial exemption if you don’t meet the requirements for a full exemption and any of the following are true:

    • You, your spouse, or a co-owner of the home moved for a new job at least 50 miles from the home you’re selling
    • You, your spouse, or a co-owner were transferred to a new work location at least 50 miles away from your current job 
    • You moved for treatment of a disease, illness, or injury, or to take care of a qualifying family member who has a disease, illness, or injury 
    • You, your spouse, the home’s co-owners, or a resident of the home experienced an unforeseeable event, such as giving birth to multiples, becoming eligible for unemployment compensation, or not being able to afford living expenses due to a job loss or employment change 
    • You or another qualifying co-owner or resident can establish you experienced another type of unforeseeable event as defined by the IRS 
    • Your home was no longer suitable for your family for a specific reason 

    Calculating a partial exemption can be complicated. You may want to work with a tax professional who can help you understand the process and ensure you report everything correctly on your tax return. 

    Mistakes to Avoid When Selling Your Primary Residence

    The capital gains exemption on your primary residence can be very valuable. Selling your home when you don’t qualify for this exemption can lead to a considerable tax bill. Avoid the following mistakes to protect your assets:

    • Don’t underestimate your basis: Include selling costs and capital improvements
    • Don’t sell the home early if you’re only a few months away from meeting ownership or residency requirements: Waiting a few months may save you a lot of money in the long run 
    • Don’t forget to consult with a tax pro: Not reporting a sale when you’re supposed to could lead to a tax assessment or even tax fraud charges 

    The capital gains tax is 15 to 20% in most cases. It is the same as your income tax rate if you sell the home less than a year after purchase. This tax can cost you a lot. A tax professional can help ensure you don’t face unnecessary taxes. 

    Get Help From the Silver Tax Group

    The Silver Tax Group can help you handle taxes, audits, and tax debt resolution. We can assist you in reporting the sale of your primary residence correctly so you can minimize your tax debt as much as possible. We can also help if you have sold your home but the IRS claims you don’t qualify for the primary residence exemption. 

    We leverage our in-depth understanding of tax laws and IRS practices to help our clients. Don’t let the IRS assess a tax against you that you don’t really owe – contact us today to learn more about how we can help you. 

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