When selling a home, whether due to an employment move, trading up, or downsizing, a homeowner-taxpayer should be aware that special tax treatment applies under certain situations when the sale is of the taxpayer’s principal residence.
Under certain circumstances, a single taxpayer can exclude up to $250,000.00 of gain on both federal and state income tax returns and married taxpayers can exclude up to $500,000.00. For married couples, the $500,000.00 exemption requires that they file a joint return in the year their residence is sold.
The determination of whether gain on the sale of a residence can be excluded from a homeowner’s income for tax purposes depends on whether the property has been owned and used by the taxpayer for a period of two or more years during the five year period preceding the sale. The five year period ends on the date title is transferred. The two year time period, for both ownership and use, does not need to be a consecutive. The time can be aggregated over the five year period. There is, however, a limitation on how often this exclusion of gain can be used. The exclusion can only be applied to one sale every two years.
For married couples to qualify for the up to $500,000.00 exemption, in addition to filing a joint return, either the husband or wife must meet the ownership requirement and both spouses must meet the use requirement. In addition, neither spouse shall be ineligible for the exclusion because he or she sold a property within the past two years. If the married couple does not share a principal residence, an exclusion of up to $250,000.00 is available on a sale that qualifies as the principal residence of one of the spouses.
If a single homeowner, who is eligible for the exclusion of gain benefit, marries someone who elected to use the exclusion benefit within the two years prior to the marriage, the now married taxpayer is only allowed a maximum exclusion of $250,000.00. If a taxpayer has more than one home, only the sale of the principal home qualifies for the exclusion of gain benefit.
There is an exception to the two year requirement for sales which permits a reduced amount of gain to be excluded from income. A reduced exclusion can apply to a sale resulting from a change in the taxpayer’s place of employment, health, or certain unforeseen circumstances. In such situations, a taxpayer is provided a reduced exclusion based on the portion of the two year period for which ownership and use requirements are met.
The Taxpayer Relief Act of 1997 modified Section 121 of the Internal Revenue Code to provide this exclusion of gain benefit. It replaced the prior law which provided rollover and one-time exclusion provisions for the sale of taxpayers’ residences and replaced it with a simpler law which no longer requires a taxpayer to continually "trade up" to benefit from substantial tax savings.