Most people who sell their home don’t have to pay capital gains tax, even if the value of the home increased substantially while they owned it. But some people do owe tax, so if you’re thinking of selling, it’s important to know whether you can escape the IRS.
Here are the rules:
As a single person, you can generally exclude up to $250,000 in gain from a home sale. If you’re married and file jointly, you can generally exclude up to $500,000 in gain.
In order to do so, you must pass two tests:
- Ownership test: You must have owned the property for at least two years during the five-year period leading up to the sale.
- Use test: You must have used the property as your principal residence for at least two years during the five-year period leading up to the sale.
The two-year periods for the two tests don’t have to be the same. So if you rented the house as your principal residence for two years, then bought it and owned it for two years but lived somewhere else, you’re probably still okay.
If you’re married and filing jointly, both spouses must pass the use test, and at least one must pass the ownership test.
An important restriction is that if you sell a house and exclude your capital gains, you must generally wait two full years before you can sell another house and exclude your capital gains. This rule can trip up people who move frequently.
However, even if you sell a new home after less than two years, you might still be able to exclude part of all of your gain if you sold the property because you had to move for a new job, had health problems, or experienced certain other unforeseen circumstances.
One other wrinkle involves people who sold a home and bought their current home before May 7, 1997.
Prior to that date, the rule was that if you sold a home and bought a new one, the capital gain on the sale was rolled over into the tax basis of the new home. So if you sold and bought a home prior to that date, the tax basis of your current home must be reduced by the “rolled over” amount.
Example: Bob and Laura sold a home in 1996 for $125,000 more than they paid for it. They immediately bought a new home for $200,000. Today, they sell their home for $600,000.
Since their gain on their current home appears to be $400,000, they might think they can escape the tax because of the $500,000 exclusion for married couples.
However, since their basis in the new home must be reduced by $125,000, their actual gain is $525,000 – and they’ll have to pay tax on $25,000 in capital gains.